Although Brits continue to speculate about the chances of a new round of quantitative easing, the Federal Reserve appears ready to launch what has been unofficially dubbed QE2, which sounds more like a royal tour than an economic policy. Yet that name resonates with most people because, like any of the monarch's visits to Canada, few understand what really goes on behind the scenes. And, more importantly, how quantitative easing is supposed to stimulate the economy.
Fear not. Here's everything you need to know, with a little help from the global economic research team at Goldman Sachs. You can expect things to play out in a similar manner if the Bank of England also decides to prime the pump.
What is QE2?
Quantitative easing is a fancy term for buying bonds. To stimulate the economy, the Federal Reserve will purchase long-term Treasury bonds from U.S. banks and institutional investors.
In theory, the cash they get in return will trickle through the economy. For instance, bank customers who get loans will probably go out and buy things, generating income for small businesses. In turn, these businesses will purchase more goods and services with the new income. This is called the multiplier effect.
But can that alone boost GDP growth by 0.5 per cent for every $1-trillion of Treasury bonds purchased, as Goldman Sachs has predicted? Probably not. QE2 is expected to work on a few levels and the examples below explain some of the more intricate ways it could help the U.S. economy.
Low long-term interest rates
Boosted by the Fed's demand, long-term bond prices will rise. According to finance fundamentals, as prices rise, interest rates fall, meaning long-term rates will drop. That should send mortgage rates down, convincing more people to buy homes. Even if new buyers don't appear, current homeowners may refinance at lower rates, giving them more disposable income. Companies are also affected. At the moment, U.S. firms are hoarding cash until the economy recovers, but low long-term rates means they will earn almost no return on that money, pushing them to go out and spend it on new machinery or hire new workers.
Stock price appreciation
If investors aren't getting a good return on bonds, they'll look at stocks. Because equities don't have a fixed return, the S&P/500 can advance quickly. Gains like that boost personal wealth, which encourages investors to spend money again. High stock prices also make companies more likely to raise new capital because they get more bang for their buck. The new money they raise can be put to good use like building factories, buying new assets and expanding operations.
Weak U.S. dollar
International investors flock to countries with the highest interest rates to get the best return possible. Once U.S. long-term rates fall, these investors will probably turn to countries such as Canada to park their money, which Statistics Canada recently declared is already happening. But to buy Canadian securities these investors must sell U.S. dollars and purchase loonies. That pushes the greenback lower, making U.S. goods (i.e. exports) cheaper for other nations.