Fed Stimulus Spending Not Without Risks

Federal Reserve Chairman Ben Bernanke confirmed yesterday that the Federal Reserve would, as most pundits predicted, engage in further stimulus spending in a bid to advance the US economy. Billed as “QE2”, this second round of quantitative easing will see the Fed buying $75 billion in treasury bills each month for the next eight months for a total of $600 billion. This follows the first round of stimulus spending in 2009 where the Fed purchased roughly $1.7 trillion in mortgages and government bonds to ease the impact of the past recession.

The obvious hoped-for outcome is to see an increase in economic activity translating into sustained economic growth. This approach however, is not without risk.

The standard call from the Fed’s playbook when trying to kick-start the economy is to lower interest rates to encourage lending and boost spending. Unfortunately, the Fed has run that play once too often and with interest rates now as low as they can go, is left with no option but to try the less-proven approach of direct investment in the economy. In other words, the Fed is revving up the printing presses.

The sudden availability of “new” money in the economy will likely lead to an immediate devaluation of the currency. While this is typically not a desired outcome, under the current situation a weaker US dollar could help spur the economy. Of course the Obama administration will not publically state that they are pursuing a weak dollar policy, but for a country desperately dealing with unusually high unemployment, this could be beneficial.

In January’s State of the Union address, President Obama made it clear that one of his goals was to stimulate job creation by decreasing the trade gap. A weaker dollar will help as goods imported into the US will become more expensive for US consumers; conversely, American exports will suddenly be more affordable for buyers whose currency is now worth more when converted to the greenback. Thus, with foreign goods being more expensive, American-made products will be more competitively-priced not only for foreign buyers, but also for the domestic market and this should boost demand, leading hopefully to a gain in employment.

Surely this is a good thing, right? Certainly. In the short-term at least. But there are greater implications that must be considered.

First and foremost is the possibility that a devaluation of the US dollar will force other exporting nations to follow suit in order to keep their currency relative to the buck. As these exporting nations maneuver to outdo each other comes the very real possibility of touching off a “currency war” and worse still, the introduction of other protectionist measures. Exporting nations including China, Japan, and the EU may find it necessary to act to protect their own exporting industries and this could quickly spiral out of control with negative consequences for global trade.

The other risk that must be considered is that the stimulus could work too well. After all, there is a fine line between robust growth and crippling inflation and you can’t exactly turn the economy around on a dime. Despite all that has happened since the big crash, the US still represents the world’s largest economy and once it has picked up a bit of momentum, often times there is little else you can do but hang on for the ride.

Finally, there is the risk of the unknown. Even Federal Reserve Chairman Bernanke alluded to this when he said that “purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates”.
In yesterday’s statement, Bernanke drew a straight-line connection between easing credit conditions and recovery, noting that “easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance.”

I believe a more salient question revolves around the issue of business and consumer confidence – are traditional spenders really ready to take on loans and engage in spending programs right now? And isn’t this how we got in trouble in the first place?

It’s grand that Bernanke believes this will make it easier for individuals to buy new homes. However, from what I can see, the market is awash with bank-owned properties already while a new wave of foreclosures waits in the wings. I’m not sure that we can count on a housing-fuelled recovery any time soon.

And just because there is plenty of cheap cash available for companies to expand their operations ignores the fact that the entire manufacturing sector is operating far below capacity now. Why exactly would they be looking to expand and hire workers for business they don’t presently have?

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