By Robert Klemkosky
SKK Graduate School of Business dean

QE2 is not just a cruise ship named after Queen Elizabeth II. It also means quantitative easing (QE) and is a monetary tool used by the U.S. Federal Reserve to stimulate a lethargic economy.

The Fed’s normal monetary tool is short-term interest rates which it started to reduce in September 2007, and short-term rates approached zero by December 2008.

It was a very aggressive move by the Fed but it didn’t do enough. The Fed was caught in a “liquidity trap” whereby there was plenty of liquidity in the system, but it was not being spent by consumers, invested by corporations or lent by banks. The problem was a lack of confidence.

QE2 was announced by Fed Chairman Ben Bernanke in August 2010 whereby the Federal Reserve Bank would purchase $600 billion of U.S. Treasury securities from November 2010 to June 2011.

It was called QE2 because the Fed had already purchased more than $1 trillion worth of mortgage and Treasury bonds during the financial crisis in 2008 and 2009 to stabilize the system. It did that but the economy and employment were not growing enough to bring down unemployment.

The goal of QE2 was to stimulate the economy through the wealth effect. By lowering long-term interest rates, all rates were supposed to come down, including mortgage rates and corporate bond rates.

This was supposed to create wealth by increasing housing prices, stock prices and bond prices, which would create confidence so consumers and corporations would start spending again. Another objective of QE2 was to increase inflationary expectations so consumers will buy today because prices will be higher later.

An ancillary objective of QE2 in many people’s opinions was to devalue the U.S. dollar making exports more competitive, thus stimulating the economy, and imports more expensive, thus creating inflation.

How has QE2 worked since it was announced in August 2010? The verdict is mixed, although more positive than negative. Stock prices have increased but housing prices have continued to decline, but at a lower rate.

Consumer and investor confidence has increased as the economy grew and stock prices increased. Long-term interest rates initially went up due to an improving economy and increased inflationary expectations. However, they have come back down in 2011 as the U.S. economy slowed and unemployment remained high.

QE2 is a voyage in uncharted waters and risks are abound. The biggest is that inflation rears its ugly head and exceeds the Fed inflation target of 2 percent.

Higher than expected inflation would certainly raise interest rates and hinder economic growth, perhaps even creating another recession. Another risk of QE2 is that it may have created speculative bubbles in other markets such as commodities and gold.

A third risk of QE2 is that the balance sheet of the Fed has greatly expanded from a little over $800 billion in 2007 to $2.5 trillion today; if inflation and interest rates go up, the Fed may have to sell bonds at a loss.

Finally, since QE2 indirectly devalued the dollar relative to other currencies, it may have motivated currency wars and protectionist moves in international trade.

The U.S. Fed is not alone in pursuing a QE strategy. But the Fed may find that starting QE2 was a lot easier than ending it. The exit strategy is unclear and has created a lot of uncertainty about the direction of long-term interest rates and inflation.

Since QE2 started, the Fed has purchased 70 percent of all U.S. Treasury securities issued and foreign investors the other 30 percent. What happens when the Fed’s buying power is pulled? Bill Gross of PIMCO, one of the most successful bond managers in the U.S., has already sold all the U.S. Treasury securities in his portfolio, convinced that interest rates will rise after QE2 ends. That would not be good for the economy, housing or the stock market.

If the markets efficiently process information, the impact of the ending of QE2 should already be reflected in bond and stock prices. So if you believe in efficient markets, the early prognosis is that the ending of QE2 may not be too dramatic.

Higher interest rates may not necessarily slow economy growth as long as they stay under the long-term norm. However, if long-term rates increase dramatically, above 5-6 percent, because of inflation concerns, the Fed may have to tighten monetary policy by raising interest rates.

The most likely scenario is that the Fed will continue to hold the securities purchased in QE1 and QE2 until solid economic growth is sustainable. If the odds of recession and deflation increase, who knows, there may be a QE3.