Federal Reserve officials will meet on November 2nd and 3rd, and what they will decide at that meeting will have a very immediate, and very dramatic, impact on financial markets across the world. For weeks, top Federal Reserve officials have been making public statements that have contained hints that they plan to initiate another round of quantitative easing by the end of 2010. Based on those hints, the U.S. dollar has been tanking and the stock market has been moving up. Most investors seem convinced that this new round of quantitative easing will mean more inflation but that it will also get the U.S. economy moving in a positive direction again.
But just how in the world did we get to this point?
Well, for most of the the Federal Reserve’s history, there have been two primary ways to “stimulate” the economy.
The first is for the federal government to spend more money on various programs which puts more currency into the pockets of the citizens and sparks economic activity. This is what the “economic stimulus” packages were all about. But considering the fact that the national debt of the United States is rapidly approaching $14 trillion, there is not much appetite in Congress for any more stimulus plans right about now.
The second way that has been traditionally used to stimulate the economy is for the Federal Reserve to cut interest rates. By cutting rates, it becomes cheaper to borrow money and so more people take out loans and more money starts circulating through the economy. When more money is circulating through the economy, that tends to spark economic activity. Well, the Federal Reserve has cut interest rates to nearly zero, and that hasn’t worked. The truth is that there is essentially no more room for the Fed to cut rates.
Quantitative easing is a third option. It was tried before in 2008 with limited success.
So just what in the world is quantitative easing?
Well, basically what happens is the Federal Reserve creates a bunch of money out of thin air and uses it to buy things like U.S. Treasury bonds and mortgage-backed securities.
The theory is that by injecting large amounts of money into the economy it will get people spending again and will spark economic activity.
So couldn’t the U.S. government just create money out of thin air instead?
Under the Federal Reserve system, only the Federal Reserve gets to create money out of thin air.
But is it really a good idea for a bunch of unelected, unaccountable bankers to have the power to create money whenever they want?
Of course not, but up to this point the American people have not demanded a change to the system.
So right now the Federal Reserve, which some call “the fourth branch of government”, has more power over the economy than any other institution.
It’s rather bizarre, but that is how our system works.
So exactly what is going to happen in early November?
Well, nobody knows for sure. If the Federal Reserve announces a fairly modest program of quantitative easing of just a few hundred billion dollars, it will probably have a calming effect on the U.S. dollar, but it will not have much of an impact on the economy.
If the Federal Reserve announces a very large program of quantitative easing, it will probably cause the U.S. dollar to keep plunging like a rock and we will likely see a spike in the inflation rate in the months ahead.
But will any of this actually “fix” the economy?
Of course not.
The folks over at Goldman Sachs estimate that it would take a $4 trillion injection by the Federal Reserve to get the U.S. economy rolling again.
The Federal Reserve is unlikely to do anything that extreme – at least at first.
But the truth is that any amount of quantitative easing is going to put inflationary pressure on the dollar. Whenever one new dollar is introduced into the system, each existing dollar loses just a little bit of value. When hundreds of billions, or even trillions, of new dollars are suddenly introduced into the system it can create quite an inflationary shock.
So exactly where is all of this money going to go?
Well, at first it goes to the big banks.
What the Federal Reserve does is that it tells the big banks the types of assets that it plans to purchase (for example U.S. Treasuries), and then the big banks stock up on those assets.
Then the Federal Reserve comes along and buys up those assets for a little more than anyone else would be willing to pay.
What this amounts to is a massive “backdoor” bailout for the big banks without having to go through the hassle of dealing with Congress. The big banks get recapitalized and make a huge profit, the Federal Reserve is happy because it has injected huge quantities of money into the economy, and most of the American people don’t even realize what just happened.
Yes, it is as bad as it sounds. Rolling Stone’s Matt Taibbi recently appeared on MSNBC and described exactly how this happens in a little more detail….
In light of all this, what should we all be watching for next week? Well, the whole financial world is going to be eagerly anticipating the Fed decision. If no quantitative easing is announced, it will deeply disappoint many investors and could even set off a bit of a stock crash. If a huge quantitative easing program is announced, it will delight the stock market but it may crash the dollar.
So what we are most likely to see is the announcement of a relatively modest quantitative easing program to start out with. Of course once the Fed opens the door, it is hard to say where all of this will end. In fact, there has been some talk that the Federal Reserve may decide to make quantitative easing a “semi-permanent” thing.
Yes, that is how bizarre our financial system has become. The Federal Reserve has gotten completely and totally out of control, and the American people have essentially no say in the matter.
All we can do is wait and watch what will happen on November 2nd and 3rd.
The moment of decision cometh.