Finance

Happy Quantitative Easing Week!

Fed

The Fed. Karen Bleier/Getty Images hide caption

itoggle caption Karen Bleier/Getty Images

The Fed hasn't actually come right out and said it's about to create hundreds of billions of dollars out of thin air. But sometimes the the Fed doesn't come right out and say things.

So, in the way these things go, everybody is assuming that the Fed will announce this Wednesday that it's about to create hundreds of billions of dollars out of thin air.

The cool kids call the soon-to-be-announced plan QE2, short for "quantitative easing, part II."

The first quantitative easing ever in this country — QE1, if you will — started just a few years ago, when the Fed created more than $1 trillion to buy mortgage bonds. That was a response to the acute phase of the crisis, when markets were locked up and regulators were afraid the financial system might fail.

QE2 is a response to this grinding recovery-that-doesn't-feel-like-a-recovery that we seem to be stuck in.

In QE2, the Fed will create money to buy long-term bonds. That's supposed to drive down interest rates. The idea is to get people to borrow and spend more money, and companies to borrow more money and hire more people.

In part because QE has been used so rarely, nobody really knows how well it will work, or whether it will backfire.

Interest rates are already super-low. And big companies are sitting on a lot of cash. So it's not clear whether making interest rates go even lower will do much to change behavior.

What's more, if the economy starts to come back sooner than expected, QE2 could help drive inflation to a rate that's too high.

And QE2 is also likely to make the value of the dollar fall. That makes U.S. exports cheaper in other countries, which helps U.S. companies. But a falling dollar could continue to drive the global "currency war," by pushing countries around the world to devalue their own currencies in return.

Some Fed leaders are opposed to QE2. But Ben Bernanke and several other key Fed officials clearly feel compelled to act.

The Fed has two key mandates: keep prices stable, and keep unemployment low. The Fed is clearly failing on the unemployment front. What's more, the Fed's key policy committee is also nervous that inflation is a bit too low, and at risk of sliding into deflation.

Here's how Bill Dudley, president of the New York Fed, put it in a speech last month:

Viewed through the lens of the Federal Reserve's dual mandate—the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory.

From the president of the New York Fed, "wholly unsatisfactory" counts for high drama.

With everybody assuming QE2 is a done deal, the main questions at this point hinge on the details. How much money will the Fed spend this time? Estimates range from a few hundred billion to over a trillion.

The Fed may give itself a lot of latitude. Fed officials may announce that they're going to start a new round of QE, without putting a fixed limit on how much money they will spend. That would allow Fed officials them to expand or contract the program in the coming months, depending on what happens in the broader economy.

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