Can Federal Reserve boost the economy?

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Lower mortgage rates, more jobs, expanding businesses — all because of a fuzzy concept called QE2? Perhaps.

First, what’s certain: This QE2 isn’t the famous luxury ocean liner. Rather, it’s shorthand for a second round of “quantitative easing” by the Federal Reserve.

The first round, or QE1, began in late 2008 and was greatly expanded in early 2009 before it was discontinued last spring.

Ken Thomas

Although it sounds complicated, quantitative easing is basically a Federal Reserve plan to inject cash into the banking system. If banks lend out the money, the recovery could gain traction. Theoretically, QE2 also could prod the inflation rate, easing fears of deflation.

But critics note that other experiments with quantitative easing — besides QE1, Japan has made several efforts — have produced unspectacular results.

Federal Reserve Chairman Ben Bernanke has hinted QE2 is coming. Today’s expected announcement following the Federal Open Market Committee meeting could provide the first specifics.

Bankrate asked longtime Fed watcher Ken Thomas, a lecturer in finance at the University of Pennsylvania’s Wharton School in Philadelphia, to explain how QE2 likely will work, and how it may affect your pocketbook.

What is quantitative easing?

Quantitative easing is a fancy word for when the Fed goes in and buys long-term securities from banks — primarily 10-year Treasuries. The central bank creates money out of nothing. The theory is that, by mopping up securities, banks will have so much cash that they will have to lend. They’ll have no choice because they’ll be so flush with funds.

How much will the Fed likely spend on QE2?

The magnitude will probably be around $1 trillion to $1.5 trillion. Anything less will seriously disappoint. It shows you how bad this situation is.

Doesn’t the Fed traditionally stimulate the economy by cutting interest rates?

Traditional procedures no longer work. Fed funds, which influence short-term interest rates, have been cut to near-zero and it hasn’t helped. In economics, we say it’s like pushing a string. Nothing happens.

QE2 is necessary because Bernanke made a mistake. With QE1, the Fed spent $1.7 trillion between March 2009 and March 2010. He pulled back way too early. The recession was over, but the crisis wasn’t. We’ve had crises without recessions and recessions without crises. This time, we got both.

Unfortunately, Bernanke has a history of underestimating the severity of things, like when he said in 2007 that the subprime problem was contained.

How will consumers be most affected, positive and negative, by QE2?

We’re hoping it works on long-term rates. Bernanke is a student of the Depression, and QE1 was an alternative effort to bring long-term rates down. That impacts mortgage rates. The idea was to revive the economy by reviving housing. With most people, their biggest purchase is a home. It will help borrowers.

But this will not help savers. We’re getting next to nothing on CDs.

How will QE2 affect savers, who have been suffering from low interest rates?

The purpose of QE2 is to lower long-term rates. While lower rates mean good news for borrowers, it is bad news for savers. The low rates we have now will be even lower. How low are CD rates? More and more bankers now start off answering your “What is the current rate?” question by using the word “point.” That is not what savers want to hear. Again, good news for your friend buying or refinancing, but bad news for (CD savers). Also, good news for bankers, whose cost of funds will drop even further, thereby boosting spreads and profit margins.

Do you think it will work?

I would say there’s a good chance; it has already had a favorable impact on the markets. If he did not do QE2 it would be a disaster. With the election, I think this is probably the most relevant 24-hour news period this year.

What could limit QE2’s effectiveness?

First of all, people don’t have the credit scores (to get mortgages). And it’s not that easy to refinance. Mortgages may go to 3½ percent or 4 percent, but that’s just for those with good credit.

There’s so much uncertainty about the economy. No one will buy houses or hire people or build plants. Obama is hoping Bernanke will get the unemployment rate down.

How does Fed leadership in this crisis compare to previous eras?

Greenspan would have the minutes written before the meeting. Bernanke, as a professor, is more democratic. The Fed has become a committee. But this Fed is lacking credibility because of its dissension. It has failed to provide a consistent message. Greenspan would have never stopped QE1.

Find out more about what the Federal Reserve decided on Nov. 3, 2010, in this story: “Fed meets, starts QE2.”