Fed to Engage in Second Round of Quantitative Easing

BY Elizabeth Shell  November 3, 2010 at 3:10 PM EDT

The Fed wants you to stop saving and start spending.

That’s the takeaway from today’s Federal Reserve announcement, in which Chairman Ben Bernanke, as expected, announced that the Fed will be investing hundreds of billions of dollars to energize the sluggish U.S. economy in a second round of quantitative easing.

Through the second quarter of 2011, the Fed will spend $600 billion on securities at a rate of around $75 billion a month “(t)o promote a stronger pace of economic recovery.”

Quantitative easing, or QE, is a tool to lower interest rates on securities and thus encourage spending. (The Washington Post has produced an interactive explainer on how the Fed’s actions might influence the economy.)

No matter how it plays out, this latest Fed move won’t be a cure-all.

“I don’t think anyone at the Fed believes this action in and of itself will take us from 9.6 percent unemployment down to where it should be,” said Martin Eichenbaum, professor of economics at Northwestern University.

Rather, Eichenbaum cautions that Bernanke is exhausting the tools at his disposal, and that it’s a balance of risks where the Fed has to take it’s best guess in an imperfect world.

“Bernanke’s done everything he can,” Eichenbaum added. “He doesn’t want to go home at the end of the day with a bullet still left in the gun.”

President Obama acknowledged in a press conference today that “we’re not there yet” in terms of creating jobs and boosting the economy.

With the two main goals of the Fed to keep prices stable and employment high, today’s actions are seen as a last-ditch effort to ease the financial downturn plague of the last few years and get the economy growing.

Traditionally when an economic tweak is needed, the Fed adjusts interest rates: pushing rates higher to slow growth and investment, and reducing rates to encourage growth by making money cheaper for companies to borrow, thus giving them an incentive to expand.

But with short-term interest rates remaining at near zero since late 2008, the Fed has turned to other mechanisms. Between December 2008 and March 2010, the Fed bought $1.7 trillion of securities — thus lowering yields — in a first round of quantitative easing. This action was largely seen as successful in keeping the economy out of a nosedive after the financial collapse two years ago.

Together, a zero percent short-term interest rate and increased bond purchases should continue to make credit cheaper, so it is easier for consumers to get a home loan or for businesses to expand.

This second round doesn’t come without controversy. Opponents fear downward pressure on the dollar could spark international currency wars, with little positive effect on the economy and price bubbles.

The immediate danger, according to Reuters’ global editor Chrystia Freeland, is high inflation and a loss to the Fed’s credibility that it can manage inflation.

Photo by Bloomberg Contributor/Getty Images.