Why the Fed's bold move won't work

chart_fed_security.top.gifThe Fed has pumped nearly $2 trillion into the economy in the past 2 years, and is expected to announce additional asset purchases at its meeting Wednesday. By Chris Isidore, senior writer


NEW YORK (CNNMoney.com) -- The Federal Reserve is likely to announce a plan to pump more money into the economy next week. But some economists worry that the move won't work.

The Fed is expected to announce hundreds of billions of new asset purchases, particularly long-term Treasuries, in an attempt to jump start the struggling U.S. economy.

The theory is that this so-called quantitative easing will further drive down interest rates and encourage businesses and consumers to borrow and spend more. The Fed's decision is expected to be unveiled at the conclusion of its two-day meeting next Wednesday.

Because the Fed already made about $2 trillion in similar purchases during the Great Recession, the next round has been dubbed QE2 by many economists and investors.

Critics of the Fed -- and even some Fed members -- point to various unintended consequences QE2, including the possibility of a new asset bubble in financial markets, a return of inflation at painful levels, and even a currency or trade war with U.S. trading partners due to a weakening dollar.

But some economists say the biggest problem with more easing is that such a move will have little if any positive effect on the economy.

Even if QE2 leads to lower rates, it's not as if rates are high currently. Businesses and consumers aren't borrowing or spending as much because of a lack of confidence and a desire to repair their own balance sheets.

Personal savings rates are up and businesses are sitting on record amounts of cash. Bank lending officers are reporting very weak demand for loans -- and some say QE2 is unlikely to change much in the credit markets.

"I think people are wasting time talking about monetary policy," said Richard Koo, chief economist with the Nomura Research Institute in Tokyo and an expert on the massive quantitative easing efforts by Japan during the past two decades. "No one is borrowing money, even with rates near zero. So the economy has little reason to respond to QE2."

Koo's doubts about the effectiveness have been echoed in recent days by a number of top economists and analysts, including Nobel Prize winning economist Joseph Stiglitz and Bill Gross, manager of the world's largest bond fund at PIMCO.

Gross wrote in his most recent outlook that the economy is now in a "liquidity trap" -- in which lower interest rates no longer have any impact on spurring borrowing or spending.

"Escaping from a liquidity trap may be impossible, much like light trapped in a black hole," Gross wrote. "Just ask Japan."

Fed chairman Ben Bernanke has maintained that the Fed's earlier round of quantitative easing was successful in helping to stop the economic free-fall in 2008 and early 2009. But others question that claim.

Lakshman Achuthan, managing director of Economic Cycle Research Institute, said there's a case to be made that unusual steps the Fed took to buy assets such as commercial paper and consumer debt after financial markets seized up in September 2008 had a more significant positive impact on the economy.

Achuthan said it is tougher to make the argument that the purchases of $1.25 trillion in mortgages and $300 billion in long-term Treasuries that started in March of last year helped turn around the economy and lift it from recession.

He added that the new round of QE may be coming too late. To have any chance to work, it needed to be put in place before the economy started to slow earlier this year.

The annual pace of economic growth in the third quarter was 2%, according to the government's gross domestic product report Friday. That's down from GDP growth of 3.7% in the first quarter.

"The single most important thing is getting the timing right," Achuthan said. "What we've seen is that with the Fed is that it is pretty reliably behind the curve all the time."

Many Fed policymakers are also not convinced that more easing is the right idea. Kansas City Fed President Thomas Hoenig, who currently is a voting member of the Fed's policy committee, said in a speech at the University of Kansas earlier this week that trying to spur the economy through asset purchases is a "bargain with the devil."

Hoenig has consistently argued this year that the economy is slowly recovering and that further stimulus efforts from the Fed are unnecessary. He has been the most vocal in his arguments but other regional Fed presidents have also publicly stated their reservations about more easing.

Paul Ashworth, senior US economist for Capital Economics, said the lack of consensus among Fed policymakers is in itself another problem. He argues it will probably mean the Fed won't wind up agreeing to purchase as much assets as necessary to help the economy.

"The bottom line is that we don't believe additional quantitative easing will make any meaningful difference, particularly not in the limited amounts the Fed is likely to start with next week," he wrote in a recent note. To top of page

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