QE2 or the Titanic? The Fed's $600 billion injection

November 4th, 2010
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Contributed by: Aswath Damodaran
The big news of the moment (other than the election) is the Fed's decision to inject $600 billion into the economy, as a monetary stimulus to get the US out of a recession. Here is Bernanke's rationale.

Will it work? For a monetary stimulus to actually stimulate the economy, it has to change how consumers behave. Since consumers do not get any of the cash directly, the only instrument that the Fed can hope to affect is interest rates. In theory, the monetary stimulus will push down interest rates and thus unleash more borrowing by consumers and companies. I see four problems:

1. Level of interest rates: If short term rates were 5% and long term rates were 7%, I can see the potential for lower interest rates inducing more borrowing and higher consumption. But short term rates are already close to zero and long term rates are at historic lows. If people are not borrowing money at 4% (long term mortgage rates are down to that), what makes the Fed think that a 3.5% rate will induce them to do so? As for companies borrowing money, why should they when they are sitting on huge cash balances?

2. Existing leverage: The average US household already has too much debt, some of it reflecting a hangover from excessive credit card and other borrowing in the good times and a great deal of it a result of the housing boom and bust. Assuming QE2 works, is it a good idea to induce consumers to borrow more. It may create some short term growth, but are we not setting ourselves up for the next bubble bursting?

3. Inflation fears: The power of monetary stimulus rests on the credibility of the central bank. If investors trust the central bank to keep inflation in check in the long term, they will respond to the stimulus by lowering interest rates. If, on the other hand, that trust is lost, a stimulus can actually be counterproductive. The pumping of money into a system that is already flush with cash and facing potential deficits down the road will raise the inflation bogeyman, which in turn will push up interest rates. I am not convinced by Bernanke's twin rejoinders: that existing inflation is very low and that the last stimulus did not create inflation. That was because the last stimulus did not work. If this one does, then what?

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