QE2 likely won’t help U.S. economy

While the stock markets have (eventually) responded enthusiastically to the Federal Reserve’s second round of quantitative easing, economists question whether the program will have the desired effect of re-inflating the U.S. economy.

At best, the Fed appears to have simply ensured interest rates will remain at rock-bottom levels at least until June. That would be great news, if American banks were actually lending to smaller businesses.

“The Fed can declare its mission a success if inflating its balance sheet keeps interest rates at their floor and credit to consumers and small business eases further,” writes Francis Généreux, senior economist at Desjardins Financial Security.

But he points out that so far the Fed has not been particularly successful in prompting better access to credit. Even it QE2 succeeds in this regard, the U.S. central bank will have to keep a close eye on inflation and its affect on exchange rates.

“The further inflation of the Fed’s balance sheets is raising a few concerns: the risks related to long-term inflation and the value of the U.S. dollar could grow. It could also lead to an intensification of the currency war,” Généreux warns. “Although core inflation has been weak lately, investors have recently been more concerned about the price situation once we get past the current economic problems.”

James Marple, senior economist, TD Economics, agrees that QE2 might not have the desired affect on growth, as households ratchet down spending in an effort to reduce debt.

“There are considerable limitations on how effective QE can be in boosting economic growth,” he writes. “Credit will continue to be constrained by household deleveraging and uncertainty in the housing market, and there is little reason to believe that an additional $600 billion in reserves will significantly alter this paradigm. At the very least, QE2 should succeed in holding down interest rates and give more time for the economic recovery to gain momentum.”

Some are already predicting “QE3” — a third round of quantitative easing to follow the current program.

“We see the conditional linking of purchases to evolving economic conditions as key in ensuring that the purchase program remains open-ended in nature and may eventually exceed the initial $600bn commitment should conditions warrant,” wrote Michael Gapen, director, U.S. Economic Research at Barclays Capital.

One desirable affect of QE2, however, could be that it gives investors a near-guaranteed exit from shorter-dated Treasuries. In the spring of 2010, bonds were dubbed the next asset bubble, after investors stampeded into the perceived safe haven asset throughout 2009 and into 2010.

With the Fed offering to take on an additional $600 billion of U.S. debt, investors may want to take advantage of this guaranteed buyer and rotate out of overweight positions in U.S. Treasuries.

(11/04/10)