Fed meets, starts QE2

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The Federal Reserve will drop bundles of cash onto banks. Will much of that money trickle down to consumers?

The central bank launched QE2 today, right on schedule. “QE2” stands for the Fed’s second round of quantitative easing. That’s the fancy term for pumping banks full of cash in the hopes that they will lend it to consumers and businesses.

“It’s essentially become a euphemism for printing money,” says Matthew Kaufler, portfolio manager for Federated Clover Investment Advisors in Rochester, N.Y. “Technically, the Fed wants to purchase government bonds from banks and put more liquidity into the system.”

In other words, the Fed is giving banks cash in exchange for government IOUs. The goal is to dissuade banks from hoarding the cash, and instead to lend it. That, in turn, is intended to spur spending by businesses and consumers, which would create jobs.

The central bank said it would buy $600 billion in Treasury securities over the next eight months, about $75 billion per month. In addition, it will plow about $35 billion per month in paid-off mortgages into Treasury purchases. 

As expected, the Fed’s rate-setting Open Market Committee kept the target for the federal funds rate near zero. Specifically, it’s in a range between zero percent and 0.25 percent. The federal funds rate, also known as the overnight rate, has been near zero for 23 months. The Fed pushed the overnight rate that low in hopes that low interest rates would stimulate the economy. Back then the unemployment rate was 7.2 percent, and now it’s 9.6 percent.

Banks make overnight loans to one another at the federal funds rate, whichinfluences the prime rate and other short-term rates. The prime rate is a base rate that banks charge to their best customers, and some other interest rates are based on it. The prime rate will stay at 3.25 percent. Rates on home equity lines of credit and variable-rate credit cards will remain unchanged. Rates on short-term certificates of deposit will remain very low. The low rates reward borrowers and punish savers, a combination designed to encourage people and businesses to spend.

The Fed tried quantitative easing before, pumping $1.7 trillion into banks. That effort ended in March. The first round of quantitative easing resulted in lower long-term interest rates. Then, after QE1 ended, mortgage rates plummeted to lows that hadn’t been seen in nearly 60 years. No one had predicted that.

Even with mortgage rates around 4.5 percent, banks have been tight with money. Would-be borrowers complain that banks’ lending standards are absurdly strict. So the Fed showered hundreds of billions of dollars on the banks and they were stingy with it.

“You put a ton of money into the system, which is kind of what they’re trying to do with QE2, but if it’s not being moved into the system, if the engine doesn’t really kick over and create some horsepower, it’s just sitting there,” says Jim Svinth, executive vice president of capital markets for mortgage lender loanDepot.com. “That’s kind of what we saw with the first round.”

Instead of lending to businesses and consumers, banks held onto much of the Fed’s largesse to bring their capital ratios back into line, Svinth believes.

Maybe this time will be different. Svinth says he’s skeptical, because the real problem is unemployment, and “I don’t think the Fed can really affect what, in essence, is a structural employment issue, not just a cyclical one.”

Kaufler has his doubts about QE2, too. “You have a very demoralized business community or banking community, given what’s occurred, and there’s been a real reluctance to step up and start lending again,” he says. “So you can pump as much money you want in there, but until there’s confidence in the system again, both on the parts of borrowers and lenders, the quantitative easing moves are not necessarily going to promote the type of real economic growth that the Fed’s trying to induce.”

In its rate policy statement, the Fed said inflation is too low. It said a higher inflation rate would be consistent with more employment. Typically, whenever the Fed wants to goose the inflation rate higher, it cuts the federal funds rate. But the federal funds rate is near zero and can’t be cut, so the next step is quantitative easing.

“To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities,” the bank’s policy statement said. That was the announcement of the commencement of QE2.

The Fed owns hundreds of billions of dollars’ worth of mortgage-backed securities. Each month, about $35 billion of those mortgages are paid off when the homeowners sell, refinance or get foreclosed on. That’s $35 billion in cash that the Fed gets every month, and the central bank said it will buy even more Treasury debt with that money. Through the end of March, the Fed expects those Treasury purchases to total $250 billion to $300 billion. That’s on top of the $600 billion of new cash created under QE2.

One member of the Open Market Committee opposed QE2: Thomas Hoenig, president of the Federal Reserve Bank of Kansas City. He is known as an inflation hawk, and has voted repeatedly against the Fed’s policy of promising to keep rates exceptionally low “for an extended period.”

“Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy,” the Fed statement said.

The Open Market Committee’s next scheduled meeting is Dec. 14.