The most recent issue of our quarterly newsletter, Portfolio Insights, is now available.  You can click here to access the issue.   A common theme throughout the issue is today’s low-yield environment and the prospect of the Federal Reserve embarking on another round of quantitative easing.

Quantitative easing is when the Fed prints dollars and buys government securities to increase the money supply.  This, in turn, lowers long-term interest rates and spurs more borrowing by businesses and consumers.  The first round of quantitative easing (QE1) in 2009 did just that; interest rates fell, which allowed corporations to borrow cheaply and triggered mortgage refinancing that put more money into homeowners’ pockets. 

Fed officials say that a second round of quantitative easing (QE2) will depend on the health of the economy.  Recent economic data continues to show weakness.  Manufacturing has slowed since the spring and employment data remains anemic. 

The official announcement will almost be a formality at this point – markets have already priced in Fed purchases of somewhere between $500 billion to $1 trillion in Treasury debt.  As a result, it is unlikely that QE2 will bring down rates as much as QE1 did, simply because the market already reflects the Fed’s purchases.

QE2 is also unlikely to have the impact on economic growth that QE1 had, because interest rates are already super low and have been for a long time.  According to USB economists, $500 billion in purchases from November until the end of 2011 would increase real GDP by 0.4 percentage point by year-end 2011.  This translates into 400,000 more jobs by the end of 2011, or 30,000 new jobs added per month.  Not very impressive in my opinion and not enough to meaningfully reduce the unemployment rate. 

QE2 is most likely to impact the economy by lowering the value of our currency.  A cheaper dollar gives U.S. exporters an advantage in global markets, which is important while the American consumer is spending less.  More exports would also be a boon to the manufacturing sector that was driving GDP growth and job creation in the first half of 2010, but slowed in the third quarter amid weakening demand. 

Increasing exports by devaluing our currency isn’t that easy though.  Other countries have to let their currencies rise against the dollar, which would hurt their exports, and no one seems willing to do so.  Another caveat to devaluing our currency is that a cheaper dollar means higher commodity prices. Consequently, U.S. consumers will have to spend more on necessities like gasoline and food. 

In my opinion, the marginal return of further monetary easing is diminishing at this point.  The Fed can pour more money into the economy, but it can’t force lending, borrowing, spending, or investing.  And the more bonds the Fed buys, the harder it’ll be to sell them without shaking up the markets and economy.  I also worry about the Fed’s ability to control inflation in the future when money eventually does begin to circulate throughout the economy.

In addition, super low interest rates encourage people to take excessive risks.  Many argue that the Fed’s easy monetary policy in the early 2000’s were to blame for the global credit binge and housing bubble that led to our current dilemmas.

Fed officials seem to acknowledge these concerns, but it sounds like they believe the benefits outweigh them.  Only time will tell.  It’s possible the Fed will announce plans for QE2 following their two-day policy meeting ending November 3.  Buckle up for a wild ride in the market that week, which also has midterm elections on November 2 and the October employment report on November 5.

Thanks for reading and have a great day.

Peter Lazaroff, Investment Analyst

www.acrinv.com