Why the Fed's Quantitative Easing Is Overblown This Time

Anybody expecting the Fed’s actions to rally the markets—like last time—will end up burned.

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When the Federal Reserve outlined an aggressive "quantitative easing" plan in March 2009, investors were startled. The Fed had already embarked on a plan to buy about $500 billion worth of government securities, which Fed chairman Ben Bernanke had described as "credit easing" meant to pump money into banks so they'd lend more. Then the Fed dramatically raised the stakes, announcing it would buy an additional $1 trillion worth of government debt and mortgage-backed securities to further stoke the economy.

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The "shock and awe" approach worked. Bond prices jumped and long-term interest rates fell, just as the Fed had intended. Stocks rallied on the day the Fed announced its big QE plan, and kept on going. The Fed's announcement, in fact, effectively ended the worst stock market slide in decades. From its low point in March 2009, the S&P 500 surged by about 83 percent over the next 13 months—topping out right around the time the Fed ended its huge spending binge.

QE1, as the Fed's original plan is known, was supposed to pump some air into the economy, then wind down as growth picked up on its own. But that hasn't happened. GDP growth is slowing to a paltry 2 percent or less, not accelerating as the Fed hoped it would 18 months ago. Most companies still aren't hiring, with the unemployment rate likely to once again hit 10 percent or higher. Instead of the inflation that would normally happen when the central bank injected over $1 trillion into the economy, there's a risk of deflation, which is a far more pernicious problem. And the Republican surge in the midterms severely reduces the odds of any more fiscal stimulus, which Bernanke would like to see.

So the Fed is at it again—except this time, quantitative easing will probably have far less impact on the economy. Investors hoping for another huge market rally may end up deeply disappointed. And if QE2 fails to meet inflated expectations, it could even do more harm than good. Here are four reasons why:

It's much smaller than before. The Fed plans to buy an additional $600 billion worth of government securities through mid-2011, less than half of what it purchased during QE1. Moody's Analytics has calculated that every $1 trillion worth of Fed asset purchases would add six-tenths of a percentage point to GDP growth, and reduce the jobless rate by four-tenths of a point, over the next year or so. So quantitative easing that amounts to significantly less would have a marginal impact on growth and unemployment. On the plus side, the Fed can always enlarge its purchases, and a live QE program signals to investors that the Fed is well aware of the economy's weakness and prepared to act aggressively.

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Still, many analysts—including some at the Fed itself—worry that any additional easing makes the risk of inflation down the road unacceptably high. That in turn could force the Fed to raise interest rates while the economy is still fragile, risking another recession. Thomas Hoenig, president of the Kansas City Federal Reserve Bank and a member of the group that makes key Fed decisions, said in a recent speech that more easing was "a very dangerous gamble" and a "bargain with the devil." He also opposed the latest Fed move. That kind of opposition could damage the Fed's credibility if not much comes of QE2.

Investors are already banking on it. There's no element of surprise this time. The Fed has been telegraphing its plans for QE2 since late August, when Bernanke gave a thoroughly dissected speech in Jackson Hole, Wyo., hinting that more QE was coming. Stocks have risen ever since and are now about 14 percent higher than they were before Bernanke took to the podium that day, with investors clearly hoping to cash in on a rally like the one the Fed ignited in 2009. But this time, the rally could be much more fleeting. The markets were at a genuine bottom in March 2009, having fallen 57 percent from the peak in 2007. It was just starting to become clear that massive government intervention would help avert widespread bank failures, after all. QE1 and the Fed's bank stress tests, which came about six weeks later, effectively ended the financial panic and set the conditions for a sharp rebound in stocks.

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Today, the stock market may be overinflated due to government aid that masks the depth of problems in the economy. A set of charts posted recently at the blog Zero Hedge, for instance, illustrates how key indicators like GDP growth, employment, income growth, and home sales are all tracking below average compared to the way the economy recovered following past recessions. The only thing overperforming is the stock market. That might be because big firms today earn nearly half of their profits overseas, so they're able to cash in on rapid growth in emerging economies that are recovering faster. But it could also indicate a stock-market bubble fueled by the Fed's easy money, just as the housing bubble was. It's also possible that all the money headed for the stock market is already there, with no further gains likely from QE2. So there may be no further "wealth effect" from the value of rising stock portfolios than there has been already. The smart money is prepared for that.

Falling interest rates may not accomplish much. The Fed hopes that pushing rates even lower than the record levels they're at now will increase lending and spending. Lower mortgage rates, theoretically, should induce more people to buy homes, and more homeowners to refinance their existing mortgages, effectively putting cash in their pockets. And businesses ought to take advantage of low rates to borrow more money they can invest in equipment and people.

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The problem, however, is that the usual conduits for passing through the virtues of low rates are clogged. The foreclosures fiasco has gunked up the whole housing market, since it's not clear if paperwork flaws on thousands of foreclosures are mere technicalities or widespread fraud, and the controversy could freeze the market for months as investigators sort it out. Meanwhile, the housing bust drags into its fifth year, as buyers wait for a bottom and a sense that it's time to buy. As prices continue to drop, more homeowners are underwater and unable to take advantage of low rates to refinance. Businesses, meanwhile, have already borrowed vast amounts of money at low rates, with big firms sitting on $1 trillion in cash. Yet they're not using it to hire more workers. Instead, businesses of all sizes are waiting for one thing to happen before they start hiring: Sales to increase. Given all the slack in the economy, it's not clear how lower interest rates will help accomplish that.

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The Fed can't do it alone. The Fed is the single most powerful institution affecting the economy—yet it's still easy to overestimate the Fed's powers. Back in 2009, the Fed's actions were complemented by a big stimulus program, the bank bailouts, a tax credit for home buyers, vastly expanded FDIC loan guarantees, and a bunch of other government measures. Though it's unpopular today, the stimulus helped speed the end of the recession and propped up GDP growth when private spending had shrunk. Today, the stimulus is fading, and an incoming Congress dominated by small-government Republicans seems unlikely to add much fiscal oomph to the Fed's monetary maneuvers. That leaves the Fed trying to marshal a recovery like a quarterback whose offensive line has been depleted. Maybe Bernanke & Co. will pull off a Hail Mary pass. But the odds of a fumble are a lot higher than before.

Twitter: @rickjnewman