QE2, R2D2, π r squared…What Does it all Mean?

Quantitative Easing

Is it important?  Yes. Why? Jump to the reasons...


Quantitative Easing 2 is the Federal Reserve Board policy instituted in late 2010 to “re-liquefy” the banking system. Normally, the Board is responsible for maintaining member bank (all of the big commercial banks are members) liquidity. This translates to maintaining enough money on hand to meet the public’s need for funds. You are probably familiar with the concept of bank reserves. If you go to your bank to withdraw $1,000,000,000,000,000,000,000,000 (think Dr. Evil for Austin Powers fans) the bank would not have that on hand. Disregarding that that much money does not exist, the reason is reserves. They are only required to keep a small amount of actual cash on hand in the vault which is added to cash deposits held with the local Federal Reserve Bank to make up their reserves. The Federal Reserve Bank says it this way: “Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.”

So, how much to they have to keep in reserve? Here is the answer as of 12/30/2010

Net transaction Accounts1 from $0 to $10.7M – reserve requirement 0%
Net transaction Accounts from $10.70 to $58.8M – reserve requirement 3%
Net transaction Accounts over $58.8M – reserve requirement %10

FOOTNOTE
I know footnotes in a blog are pretty lame cutting edge, but, innovation is a way of life around here. A Net Transaction Account is a specific listing of deposits a bank must include in the total, minus what the bank is owed by other depository institutions plus certain in process collections. And you thought this footnote would be really boring.
END FOOTNOTE

Now that we have that out of the way, the Fed normally used Federal Open Market Operations to influence the interest rate and cash reserves in the economy. Cash reserves greatly affect bank ability to lend, thus influencing economic activity and ultimately wealth and inflation. 

Now the Good Stuff

Quantitative easing is generally seen as central bank expansion in order to stimulate the economy. They have done this almost daily for decades with short term securities. They buy securities from commercial banks (banks normally keep money in government bonds due to their low risk) for cash and the bank then has more money in reserve. They sell bonds to banks for cash and the bank has less in reserve to lend from. If the banks do not want to buy, the Fed raises the interest rates they will pay.

A key point in the current activity begun in November, 2010 is the Fed’s willingness to purchase longer term securities from the Treasury. It is like a super injection of cash. When they purchase securities, their prices go up (demand) and interest rates decrease. (This phenomenon will be the topic of another blog.) Since short term bond interest rates were at or close to 0%, there was no room to influence rates. Hence the purchase of longer term securities. The resulting increase in Fed reserves provides banks with an ability to lend more. It is not too much of a surprise that this increases inflation expectations. But, what are the alternatives?

Pretty near nothing from the Fed. They are in a tough spot. Unemployment, albeit a smidgen better, is still not that far off of 10%. Housing prices, the source of wealth spending in the past are not anywhere near stimulative. Factory utilization is moderate, around 76%. Gas prices are way up resulting in conservative capital investment and weak auto buying. Overall, thee way Ben (Bernanke) says it: “Excess capacity” is not shrinking at a meaningful rate.

Now for the Bellyaching

International governments are claiming that inflation is the fault of the US policy. They say that since inflation expectations for the US are up all over the world, we are wrecking their economies. They claim that because certain important commodities are generally traded in dollars - think food and oil as examples - worldwide prices have soared due to the Fed’s flooding our economy with dollars. They have to buy more dollars to buy food, oil, etc.

There are many reasons the dollar’s price changes. I do not know if Fed policies are the tipping point or not. I DO know that the inflation of basic prices in the world is having SOME effect on moods, particularly in poor economies. Since many of those governments are highly corrupt, and their economies are relatively underdeveloped, it is impossible to tell what exact affect US policy is having. The IMF is pointing all fingers here. That’s little surprise, though. They get paid to fabricate scapegoats. Ben essentially said this recently when he explained that every country has tools to control their own inflation. Go Ben.

Ben also says that the Fed can scuttle the program (begin to selll the bonds) and influence interest rates up to slow inflation in time to slow the economy down. Others on the Board of Governors have the same opinion. We’ll see.

Interest Rate Commentary

So what’s wrong with higher interest rates? That’s like asking what’s wrong with less money.  It depends. How much less?  The same with goes for interest rates. How much higher?

Next Post: Higher interest rates and your bond portfolio.

Take care!
Chris
952-230-1340

Securities offered through LPL Financial, member FINRA/SIPC. The LPL Financial registered representative associated with this site may only discuss and/or transact securities business with residents of the following states: MN, WI, VA, TX, AZ, FL.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.