It is quotes like the following that give me pause:
"By buying a lot of bonds and taking them off the market, the Fed expects to push up their prices and push down their yields. The Fed hopes that will result in lower interest rates for homeowners, consumers and businesses, which in turn will encourage more of them to borrow, spend and invest. The Fed figures it will also drive investors into stocks, corporate bonds and other riskier investments offering higher returns."
Hilsenrath, John, 2010. Fed fires $600 billion stimulus shot. The Wall Street Journal, Nov. 3.
The following is my analysis of the situation:
Complex Market
Bond prices are determined by many different factors in addition to the overall supply of money in the economy. Political stability, international tensions, inflation expectations, financing capacity, the national debt and timing of treasury issues to finance government operations, the supply and demand of bonds, world currency valuation, commodity prices, and alternative investments (stocks, real estate, gold ...) are just a few of the other factors. I am sure there are many more.
The US bond market is amazing in its ability to digest all of these factors in an orderly way to determine price. The flow of immense sums of money for various debt transactions happens smoothly. In addition to the stock exchanges, bond markets drive American commercial growth.
Though the leaders of the Fed are all well qualified and have studied the bond market intensively, I am not sure anyone is able to predict the exact effect of quantitative easing. The consensus is that the move might not help economic growth or unemployment much. The downside is unknown in terms of overall effect.
The bottom line, quantitative easing might not increase the price of bonds as much as the Fed believes, although no one knows for sure.
Corporate Profits
In the face of lower long-term interest rates, firms will refinance debt almost immediately. This will cause stronger balance sheets and lower interest expense on income statements, and improved profits.
However, business does not invest just because interest rates are low. There must be consumer demand and an acceptable anticipated return. While it is true that there is always risk, firms tend to use equity markets for raising cash to finance major new investments in plant and equipment. In general, this tendency means that lower interest rates might not do much to increase business investment. I generally look to IPO activity and venture capital as better indicators of an uptick in business investment.
The bottom line, lower long-term interest rates will add to company profits but perhaps not spur much new investment.
Beyond Risk Taking
I think the ultra-low interest rate policy by the Fed from 2002 - 2005 combined with the .com bubble of 2000 set the stage for the financial collapse of 2008. The availability of cheap money was instrumental in many pure speculative plays affecting markets as diverse as derivatives to real estate.
Further reduction in long-term interest rates might unleash a torrent of new speculation, something the US economy can ill afford as it goes through a cycle of repair.
As I have stated many times, speculation plays an important role in the functioning of markets. However, ultra low interest rates distort the amount of speculation to dangerously high levels.
The Bottom line, quantitative easing will create more speculation and the outcome is unknown.
Home Owners
If the Fed is successful in significantly lowering long-term interest rates, then there will be a wave of mortgage refinancing. This will put more money in consumers’ hands and should stimulate spending. It might also cause an uptick in new home sales. However, prices will not increase very much as there is a huge inventory of foreclosed homes on the market. This is a much larger problem than perhaps anyone realizes.
The Bottom line, lower long-term interest rates will put more money in consumers’ pockets but don't look for a large increase in home sales because of the risk involved.
The "No Place to Invest Syndrome"
Perhaps my greatest worry about the Fed's new quantitative easing program is that those who save money will face extremely low interest returns, thus driving more money into riskier assets like the stock market. This is the intended policy of the Fed and I think it will have the desired effect. Many folks that I know are desperate for a reasonable return on their savings and will likely consider riskier alternatives.
The danger is a rise in speculation and the diminishing value of business investment. Without complete knowledge of the outcome, the Fed is seeking to drive money into equity investment thus distorting the market and with probable unintended consequences.
The Bottom line, government efforts to shift private investment money from bonds to stocks is a highly risky move that is almost certain to complicate naturally occurring market tendencies toward gradual adjustment and self-repair.
Deflation
I think many are concerned that deflation and a long period of near zero economic growth is possible, much like what happened during the Great Depression (see 1937) and the Panic of 1873 . Though I do not think the situation is similar to the US, the lesson of the outcome after the Japanese bubble burst during the early 1990's is sobering. This single event is perhaps one of the most catastrophic changes in Japanese history and continues today (see Unending Deflation in Japan).
The Bottom line, the Fed perhaps has no other choice but to increase the money supply to fend off the economic death knell of deflation.
Summary
The Fed's quantitative easing program is risky and probably will not have the desired effect in terms of reducing unemployment or increasing GDP growth. I believe it is yet another move to protect the US economy from deflation as a consequence of one of the greatest asset bubbles in the history of economics.
If this outcome is successful (avoiding deflation), then the American economy will be set to grow again at rates above 3.5% on average perhaps in 2012 and beyond.
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