QE2 and Devaluing the Dollar

I’ve spent years reading about economics. Call me a nerd but I enjoy understanding how the economy works. But monetary policy? It’s pretty much voodoo to me. I’ve been doing a lot of reading to try to understand why the Fed is doing what it’s doing. Either I’m failing to understand it, or the Fed has put us on a collision course with high inflation and a worthless dollar.

The Fed is Printing Monopoly Money Monopoly Money
The administration and the Fed have been printing money like it’s going out of style. They believe that injecting cash into the economy will help stimulate it. Many experts disagree with this approach to stimulate the economy. And there’s risk with this policy. The more money you print, the less it’s worth. The dollar becomes devalued. And eventually, inflation sets in.

Inflation
What happens when the dollar is devalued? Lots of things. One in particular that we need to pay attention to is the price of commodities. They’re on the rise. Have you noticed grocery prices lately? They’re going up. And they’ll likely to go up a lot more. Cereal prices are going up. The price of milk is going up. It’s all going up.

In the last year, the cost of manufacturing has risen tremendously. The price of the materials used to create products has risen substantially. This has not yet been apparent in retail prices. Companies have held their pricing as long as they can. Who wants to raise their prices during a down economy? But it can’t last. Companies cannot continue to eat these losses and survive. In our industry, dramatic rises in the price of cotton are leading to significant increases in the prices of apparel. It’s coming folks. It’s coming.

Monetizing Debt
When the fed buys toxic assets (like mortgages from Freddie and Fannie), we’re monetizing our debt. This week when the fed announced that we’re going to buy $600 billion in bonds from ourselves, this is monetizing our debt. This has been referred to as QE2. Like printing money, this devalues the dollar. It’s been estimated that within a couple of years, that the dollar will be worth 20% less. Do you have $1000 in the bank? Well guess what. In a couple years, that $1000 is only worth $800 in today’s money. Are you watching the stock market rise this week? It’s up. Seems like that would be good news. But all it means is that we’re treading water because the dollar is worth less.

QE2
The QE of QE2 stands for quantitative easing. The Wall Street Journal explains QE this way:

It’s the electronic equivalent of starting up the Fed’s printing presses to create money for buying financial assets in the market – in this case long-term U.S. Treasury bonds. Buying bonds pushes down their yields, and the interest rates across the debt markets that are closely tied to U.S. Treasury rates.

What are the possible ramifications of QE2? Again from the WSJ:

Printing more money tends to push down the value of the dollar. While that would tend to help U.S. exports, it also risks pushing up the price of oil and other commodities, threatening an inflation surge that could be difficult to stop if the economy picks up. The dollar already has fallen substantially, and the resulting flood of money to emerging markets with higher interest rates and more robust growth is pushing up their currencies more than some of their governments want. That has led some countries to intervene to resist the rise in their currencies, sparking tensions between the U.S. and emerging markets and talk of “a currency war.”

Why the 2? Because we’ve already tried quantitative easing once to help the economy to the tune of about $1.7 trillion. You should read this article from the Wall Street Journal.

And from Investors Business Daily:

…starting in 2009, the Fed embarked on what it called quantitative easing — a fancy term for creating money out of thin air. Over a little more than a year, it bought more than $1.7 trillion in assets, mainly U.S. Treasury and agency debt.

Today, U.S. bank reserves are close to $1 trillion — an enormous amount compared with the normal $4 billion to $8 billion.

On Tuesday, with the economy struggling and many Fed officials still worried about the specter of deflation, the Fed embarked on a second round of quantitative easing, dubbed QE2. The plan is to spend $600 billion to buy even more government debt, hoping to push down long-term interest rates to boost consumer spending, home sales and business investment.

We appreciate the Fed’s dilemma. Interest rates are already at zero, so there’s nothing left to cut. That leaves gimmicks such as quantitative easing as the only tool. But we’re also concerned about the unprecedented amount of money that’s being created — funds that won’t be easily taken out of the banking system once inflation takes off.

With its latest bout of quantitative easing, the Fed will have created $2.5 trillion out of the blue. Yet we’ve had no job growth since it began. So calling it “stimulus,” as some do, is simply false.

IBD goes on to explain:

What the Fed calls quantitative easing used to be called monetizing the debt — printing money to cover a profligate government’s debts. It was anathema to a generation of economists. But not today. Given our 9.6% unemployment and a fear of deflation, lots of smart people think QE2’s the right thing to do.

But how real is the deflation threat? Not very. Reuters quotes a San Francisco Fed study that puts the threat of actual deflation over the next three years at 5% or less. Others are in the 20% to 22% range.

As for inflation, it’s already here. The dollar has plunged in value, raising prices on everything we buy overseas. Commodity spot prices hit an all-time high in September and continue to rise. Gold? Also at record highs. Oil? It has doubled in a year to $83 a barrel.

Other common goods — from rubber to sugar to copper to rare earths — are surging, with some near all-time highs.

It’s only a matter of time before these prices are felt in the cost of consumer goods. At present, home prices are distorting inflation figures. Year over year, housing costs have fallen 15 straight months.

The risk? Once the economy takes off, inflation may spike. And once inflation gets imbedded in the economy, it’s tough to get rid of. If you don’t think so, go back and review the history of the 1970s.

Bernanke is as smart as they come. But adding another $600 billion to the $1 trillion the Fed has already stuffed into the banks does nothing to boost economic activity.

And if inflation returns with a vengeance to decimate the economy as it did in the 1970s, he’ll come in for tough questioning by a new GOP-led Congress that isn’t as enthusiastic about quantitative easing as the Democrats.

China
The world is concerned about our monetary policy. China is warning us that we’re heading down the wrong road. Why? Let’s say your friend loans you $100. But the value of the dollar drops by 20% from the time your friend loans you the money, and you pay him back. The repayment is now only worth $80 comparatively.

China and other countries have been loaning us a TON of money. And we’re going to be paying them back with a devalued dollar. How long do you think they’ll continue to loan us money? And if they do, what rate do you think they’re going to be charging us for the loan? What happens when they cut off the flow of their money?

Conclusion
Don’t you find it interesting that the Fed announced QE2 the day after the midterm elections? I do. You only hide announcements like this behind the “big news” when you’re hoping that it will get buried on page 44 of the newspaper.

What does it mean that the Fed wanted to bury this news as much as possible? I’m not sure.

But here’s what I do know. We must get our financial house in order. Devaluing the dollar is not a good long-term strategy to economic growth. Deficit spending and the national debt are much bigger risks to our nation right now than unemployment and a sluggish economy. And the only way we’ll turn around this economy, and create jobs, is to fix our financial problems