By: Dr. Mike Campbell
Central banks have traditionally used interest rate policy as a tool to control inflation or boost spending. High interest rates encourage saving and choke off inflation whilst low rates can stimulate economic activity by making “cheap” money available to business.
However, faced with what could kindly be called a sluggish recovery and an interest rate at near rock bottom (0.25%), the Federal Reserve couldn’t use the traditional tools to boost the economy. In a widely predicted move, the Federal Reserve has confirmed that it will embark on a second round of Quantitative Easing (QE). This will see the Reserve pump $600 billion into the economy between now and June of next year.
The money will be used to purchase government long date bonds. This move will depress the yield (interest rate paid) on these bonds which will make US government borrowing cheaper. It should also drive investors away from the bonds in the search of more lucrative returns from their assets, hopefully providing a stimulus to investments in the stock market i.e. business.
The Federal Reserve will pay banks to purchase the bonds and, naturally, they earn commission on the deals. The hope is that this additional liquidity will be used by the banks to provide loans to businesses to facilitate investment and expansion. In turn, so the theory goes, this will lead to an upturn in employment and consumer confidence. Consumer confidence turns the wheel of domestic demand which, if high enough, will stimulate employment.
The downside is that the US government is printing money; government debt is less attractive to foreign investors and consequently, the value of the Dollar is likely to fall. As this will make US exports cheaper and imports dearer, it may be no bad thing for the US economy, but the ramifications in the global economy are not so easy to predict as other nations react.