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Quantitative Easing: The Fed’s Out of Control Gambling Habit With Your Money

November 5, 2010

The Fed is expected to announced today that it will buy $500 billion to $1 trillion in government debt, and drive already low long-term interest rates even lower. The central bank would buy the debt in chunks of $100 billion a month, probably starting immediately.

Economists call it “quantitative easing.“ It gets the name ”QE2″ — like the ship — because this would be the second round. The Fed spent about $1.7 trillion from 2008 to earlier this year to take bonds off the hands of banks and stabilize them.

Here‘s how it’s supposed to work this time: The Fed buys Treasury bonds from banks, providing them cash to lend to customers. Buying so many bonds also lowers interest rates because demand for Treasurys leads to higher prices and lower yields. Interest rates are linked to yields. Lower rates encourage people to borrow money for a mortgage or another loan.

At the same time, lower interest rates make relatively safe investments like bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, like stocks. The S&P 500 takes off and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues.

But many analysts and even supporters of the plan see dangers. It could make the weak dollar even weaker and lead to trade disputes with other countries. It could lead bond traders to believe that higher inflation is on the way, and they could derail the Fed’s efforts by pushing rates higher. Many investors argue that it may create bubbles as hedge funds and other speculators borrow cheaply and make even bigger bets on stocks, commodities and markets in developing countries like Brazil.

“If the Fed’s efforts fail we suddenly look like Japan,” Ader says. “Japan started off wimpishly, then did it again, and again and then they wound up losing a decade.”

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