Fed Sails with QE2??_No, Not the Queen Elizabeth 2, the "Quantitative Easing Program"

On Nov. 3 Ben Bernanke, chairman of the U.S. Federal Reserve, announced the Fed's latest plan to stimulate the economy. The market liked the idea, with the Dow finishing 219 points up the following day.

"Think of the Fed as a group of soldiers in a fox hole. They have fired their bazooka and their rifle ammunition by cutting rates to zero, and now they are using their pistols."
??"Ethan Harris, chief North American economist, Bank of America Merrill Lynch

The Federal Reserve announced Nov. 3 that because the "pace of recovery in output and employment continues to be slow" it will indeed instigate its proposed "Quantitative Easing Program," a measure to jump-start the economy by purchasing government bonds.

Ever since the Fed first signaled back in August it was considering a second round of monetary stimulus, investors speculated on the numbers. Guesses ranged from $500 billion to $1 trillion. The numbers are $600 billion in long-term Treasuries over the next eight months. The Fed announced it will also reinvest an additional $250 billion to $300 billion in Treasuries with the proceeds of its earlier investments.

What's the thinking behind this plan???"a slow economy and "dangerously low" inflation, prompting some economists to warn about deflation of prices and demand. Some economists believe the plan isn't going to do much one way or another.

A recent survey of top economists by Blue Chip found that most believe that even if the Fed bought a $1 trillion worth of Treasuries, it would barely impact GDP growth.

The Fed's goal with QE2 is to increase inflation. The word inflation to us mere mortals sounds alarms. In an op-ed in the Washington Post, Ben Bernanke, chairman of the U.S. Federal Reserve, explained: "Today, most measures of underlying inflation are running somewhat below two percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy, especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation."

The idea behind QE2 is to "lift asset prices," which "will make people wealthier" and more inclined to spend. Some economists believe assets are already overpriced, and if the Fed's strategy doesn't raise incomes fast enough, the asset prices will correct, i.e., dip. Another worry is a sustained period of falling prices (deflation).

The Fed has been keeping the federal funds rate near zero since December 2008. This is a benchmark for interest rates on a wide variety of consumer and business loans. The Fed asserts it will continue to hold the rate at "exceptionally low levels" for an "extended period."

Josh Shapiro, chief U.S. economist for MFR Inc., a NYC economic consulting firm, doesn't think the level of interest rates is particularly an obstacle to growth. Shapiro says the Fed has "pretty much exhausted what it can do effectively."