What is Quantitative Easing (QE 2), and how does it work? Here is how we define it:
An attempt by the Federal Reserve to reduce longer-term interest rates by buying longer-term government securities in the market for cash (which the Fed creates). The hope is that people and businesses will increase their borrowing and spending, which will help the economy grow and produce more jobs. (Example: You won’t buy a house if mortgage rates are 6%, but you might if rates are 3%.) This $900-billion policy was announced in early November by Fed Chairman Ben Bernanke.
Note that the Fed has virtual control over short term rates. The Fed controls short term rates by setting the rate at which banks can borrow from the Fed (the rate called the Discount Rate). Other short term rates, i.e., for CD’s and money markets, are based on the Discount Rate set by the Fed. Long term rates, however, are set by the market, and influenced by such things as the demand for and availability of money based on the economic outlook, banks’ willingness to lend and inflation.
One of the easiest ways to think about what’s going on is by looking at the basic economic equation: P = M x V, where P is the Gross Domestic Product, M is the amount of money in our economy (Money Supply), and V is the Velocity, or speed at which the money changes hands. You can solve for V by dividing P by M.
All about “V”. Understanding velocity starts from the notion that spending by individuals, businesses, and governments drives our economy. If spending slows, then money doesn’t change hands as readily. In economic terms, we say the “velocity” (V) of money has slowed. That’s what has been happening.
Consumers have been saving more, and businesses are holding record levels of cash; both are reluctant to spend because of economic uncertainty. Saving more means spending less. In fact, the savings rate has gone from an average of 3.5% over the last six years to 5.9% over the last two years. To offset that impact, our government has created various “stimulus” (spending) plans.
All about “M”. Money is created through the lending process (the vast majority of what we call money is actually just magnetic spots on some bank’s computer). Each time someone takes out a loan, money is created in the form of magnetic spots on a bank’s computer. More borrowing means a bigger money supply (M), but borrowing has been on a steep decline.
Enduring a Double–Whammy
Unfortunately, our economy has been hit with a double-whammy of a lower “V” and a lower “M”.
The government, through its spending as well as the actions of the Federal Reserve, is always reacting to and trying to balance M and V so that we end up with the right combination to keep our economy growing. Sometimes V gets out of hand, and sometimes M gets out of hand. Hopefully, the right adjustments are made by the policy makers to bring them back in line.
Inflation and deflation are consequences of V and M getting out of sync. Inflation is too much money chasing too few goods, so prices go up. Deflation is when prices fall because there is not enough spending.
Obviously, there is much more going on in the economy, like the effects of productivity, innovation, and new business creation. Suffice it to say that there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth rate of the economy, new population, and productivity. Otherwise, deflation will appear, and we will be forced into a lower standard of living. But if money supply grows too much, we get inflation, which is another avenue to a lower standard of living for many in our population.
QE 2 is potentially a powerful action because it is aimed at increasing both M and V. We think it’s working.