The Coming Great American Fall (Part 2)...

Like last post, I want to share another article I came across with you. This is a solid article outlining what the Fed (Federal Reserve Bank) is about to do (has done at the time of this post) in regards to “Quantitative Easing” (QE2) and the pitfalls that await us from the actions of a very desperate Federal Reserve Bank. Very educational, in my opinion, so I thought it would be good to share.

To cover our bases, understand that two policy arms exist within our economic system: fiscal policy and monetary policy.

To be brief, fiscal policy is under the control of the federal government and is related to how the government taxes and spends. Monetary policy is under the control of the Fed, and relates to the control of the money supply and changes in interest rates. Fiscal and monetary policy is a balancing act. Given that our federal government has been so excellent at maintaining a disciplined approach to fiscal policy (NOT!) the Fed has taken a much more active role over the past few years in influencing the markets to try and restore the economy.

Also keep in mind that the Federal Reserve System exists as an independent system. While certain heads are appointed, the Fed is free from the wishes of the government – their decisions do not have to be ratified by federal executive or legislative branches. Kind of spooky to think that such an independent unchecked quasi governmental arm has such incredible power to influence the markets. But I digress…

As you read the below, ask yourself this question: “Is the Fed in touch with reality?”

FYI - Any emphasis in the below article is mine. I also included notes about what actually went down today regarding the announced amounts for QE2...

The Fed's big gamble: Here's what could go wrong
The Federal Reserve readies plan to lift all boats. Who knows how it will play out?
Matthew Craft, AP Business Writer
November 3, 2010

The Federal Reserve is about to take a huge risk in hopes of getting the economy steaming along again. Nobody is sure it will work, and it may actually do damage.

The Fed is expected to announced today that it will buy $500 billion to $1 trillion
in government debt (the actual number came in at $600 billion today), and drive already low long-term interest rates even lower. The central bank would buy the debt in chunks of $100 billion a month (will be $75 billion), 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. (or so the story goes)

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.

"It's a desperate act," says Jeremy Grantham, co-founder of the investment firm GMO. Grantham says it's a clear message from the Fed to the rest of the world: "The U.S. doesn't care if the dollar weakens."

Here is a look at the ways the Fed's strategy could backfire:

DOLLAR DROP

As word trickled out over recent months that the Fed was planning a new round of bond purchases, the dollar sank. It hit a 15-year low to the Japanese yen Nov. 1. Why? In the simplest terms, a country that cuts interest rates makes its currency less attractive to the worlds' investors. The interest rate is also the investors' yield, the payout they receive. When that yield falls, the world's banks move their money into countries with higher rates. They may exchange U.S. dollars for Australian dollars then invest the money in higher-paying Australian bonds.

"The Fed aims to push up the prices of stocks, bonds, real estate, and you name it," says Bill O'Donnell, head of U.S. government bond strategy at the Royal Bank of
Scotland. "Everything is going to go up but the dollar."

A drop in the dollar can help companies like Ford that sell their products abroad. When the dollar weakens against the euro, for example, one euro buys more dollars than before. Foreign customers notice the price of the Explorer they've been eyeing
is lower in their currency, yet Ford still pockets the same number of dollars for every sale.

The downside is that a weakened dollar pinches people in the U.S. because anything produced in other countries becomes more expensive, like oranges from Spain or toys from China.

"Look around you," says Thomas Atteberry, a fund manager at First Pacific Advisors. "How many things can you find that were made in the U.S.A?"

BLOWING BUBBLES

Buying bundles of Treasurys knocks down interest rates, making borrowing cheap. But it also motivates investors to move out of safe investments into riskier ones in search of better returns. The stock market, for instance, rises in value and everyone with some of their savings in stocks feels wealthier. Ideally, it produces what economists call a "wealth effect": People who feel better off spend more.

The problem, according to some critics, is that cheap borrowing costs and buoyant markets make a fertile environment for bubbles, which eventually pop. "The effort to help the economy sets up another more dangerous bubble," says Grantham, who warned of Japan's surging real estate and stock markets in the 1980s, soaring Internet stocks in the 1990s and the housing market in the 2000s.

Stocks in developing countries are a likely candidate for the next bubble. Cash from Europe and the U.S. has plowed into emerging markets, such as Brazil and Chile, since the financial crisis, largely because these countries have less debt and faster economic growth than in the developed world.

Another concern: Hedge funds borrowing cheap money can magnify their bets, taking a loan at 2 percent to buy a security that's rising 10 percent. They sell the security, pay off the bank and pocket the rest. That's true whenever interest rates remain low. Falling rates allow speculators to borrow larger amounts. In the extreme, losses from hedge funds and other borrowers can put their banks at risk and leave governments to clean up the mess.

The game only works as long as the investment keeps climbing. When the bubble breaks, the fallout can devastate an economy.

"I think bubbles are the main villain in this piece," Grantham says.

Cheap debt provided the fuel for the housing bubble, allowing home buyers to take out larger loans on the belief that somebody else would buy the house at a higher price. Fed chief Ben Bernanke's answer, Grantham said, is to start the cycle over again by blowing a new bubble. "All they can do is replace one bubble with another one," he said.

FALLING FLAT

For others in the bond market, the greatest worry isn't that the Fed will flood the economy with dollars and lets inflation run wild. It's that the Fed will prove too timid.

"Whether QE2 works or not will be decided by the bond market," says Christopher Rupkey, chief economist at Bank of Tokyo. "Without a big number that gets the market's attention, the program they announce could be dead on arrival."

News reports that the Fed may spend less than the $500 billion bond traders have been betting on has helped push long-term rates higher in the last three weeks. David Ader, head of government bond strategy at CRT Capital, sketches one scenario if the Fed shoots too small. Say the Fed announces a $250 billion plan. The yield on the 10-year Treasury note, which is used to set lending rates for mortgages and corporate loans, could jump from 2.6 percent to maybe 3.2 percent.

"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."

So why is the Fed doing QE2? Answer: to get people, businesses, and institutions to borrow money and spend in order to pump up our economy.

Does this not sound completely asinine to you as it does me?!?!?! If people would just borrow more money to spend and pump up our economy, things will get better…fa-la-la, tra-la-la??? You’ve got to be kidding me!

The problem is debt! Not the affordability to be able to access it!

I think the Fed has completely lost touch with reality here and is putting us in a place of more risk.

QE2 is an academic exercise…one of the few remaining tools in the tool bag for the Fed. They are getting desperate. It may seem like sound economic reasoning to institute QE2, but desperation often clouds judgment. This is not a move grounded in reality.

The news media has been much more focused on the elections...however, the real news may have just happened under our noses in QE2. If the Fed's bet here doesn't pay off, we may be in for a longer economic recovery and suffer worse consequences than had they just left things alone.

Don't say you weren't warned...