The Fed Will Create More Money, but Will It Help?

There isn't much surprise left in the expected Federal Reserve decision to embark on a program of buying bonds in hopes of stimulating the economy. It's just that more and more people think it's a bad idea.

The Fed is likely to announce the move at the end of a two-day meeting of its interest-rate-setting committee on Wednesday. Fed Chairman Ben S. Bernanke has been hinting at this policy course since August, and leaks from the committee suggest the policy will be adopted, but perhaps on a smaller scale than analysts had earlier expected.

According to The Wall Street Journal, which has been used by members of the committee to get their views out in public, the bond purchases are likely to be a few hundred billion dollars over the next several months. Some had expected the amount to be well over $1 trillion -- a "big bang" like the $1.7 trillion purchase program the Fed started in March 2009, to keep the economy from collapsing. But the Journal says that's not likely to happen.

Chasing Zero

The purchase of Treasury bonds is designed to get money pumping through the financial system. It works like this: Because the primary interest rate is already at zero, the Fed has to resort to other means to lower returns in the greater marketplace. So the Fed creates money out of thin air and buys bonds from the markets. The hope is that this demand for the bonds will cause their prices to rise, which results in lower interest rates. If interest rates are lower, the theory goes, people and businesses will have more incentive to stop hoarding their savings and start borrowing and spending.

The concept of bond buying, which is known as quantitative easing, has some fierce critics even within the Fed, including Thomas Hoenig, president of the Kansas City Federal Reserve Bank. Hoenig says expanding the money supply is "a bargain with the devil." Even notables like Nobel-prize winning economist Christopher Pissarides think it's a bad idea, saying there already is enough money floating around the American economy.

The conventional view is that the Fed has little choice but to act. "While a lack of liquidity is not the problem in the economy," say Bank of America (BAC) analysts, "quantitative easing is the best of a bad set of choices for the Fed. [It] can stimulate the economy by depreciating the dollar, and boosting the stock and bond markets. Moreover, the alternative of doing nothing could seriously damage confidence."

Not Much Firepower Left

But there is also growing concern from economists and businessmen on Main Street that the program won't work.

"The impact of quantitative easing is going to be very minor," says Robert Barone, an economist who is a partner at Ancora West Advisors, a Reno, Nev., money-management firm. "The Fed has already shot all of its major artillery, and all they have left now is a .22 rifle."

Barone says banks are already flush with cash, and the loan rate has actually been falling rather than rising. So giving them more money isn't going to get companies the loans they need. He also says interest rates are already at historic lows, so making them marginally lower isn't going to do much beyond spurring the wealth effect -- the notion that because things might be getting better, people will start spending again.

Worried About Inflation

Stephen Stanley, chief economist at Stamford, Conn.-based Pierpont Securities, says the bond-buying program may result in stoking inflation above acceptable levels. He points to the fact that prices for some assets such as gold and commodities have rocketed higher in the past few months. Gold is up 14.75% in the last six months.

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Stanley says it's also not certain if quantitative easing will accomplish the Fed's main goal of lowering interest rates. He notes that after the first round in March 2009, yields on 10-year Treasury bonds fell by 0.5% in one day. But they bounced back to the same level within a month and were 1% higher within two months.

He said businesses aren't spending now because of the uncertainty over government policies such as taxes and regulation, which the Fed can do little to change.

Stanley maintains that while households are saving more than in the past, the government is running massive deficits so that the net result is the country has a negative savings rate. So, the Fed doesn't need to create incentives to get people to stop saving money, he says.

Is the U.S. in a "liquidity trap"? That's when no matter how much the Fed increases the money supply, it doesn't affect the economy. Barone thinks so. "Even if they create more money, it's not being turned over -- people simply accumulate it," Barone says.

Playing a Weak Hand

Small businesses will get hurt, he believes, because quantitative easing will cheapen the value of the U.S. dollar and cause import prices to rise. But exports won't get the kick they need because it has taken 20 years for manufacturing companies to set up shop in China and elsewhere in the developing world, and it would take a very long time to reverse that trend.

So whether you're worried about inflation or the money supply, it looks like the Fed is playing a weak hand. And not many analysts expect it to win, no matter what the details of the program coming this week.