The chief role of the Federal Reserve used to be to fight inflation. It was a role the Fed played well, generally holding inflation in check since the 1980s.
With the launch of a second round of quantitative easting (QE2), the Fed is switching direction and is seeking to increase inflation.
Why would we want higher prices – especially at a time when we need more consumer spending?
Because, the Fed believes a little more inflation is needed to stimulate the economy. For some time now, the Fed has feared deflation. When prices drop, profits decrease, stock prices drop, and unemployment and bankruptcies increase. Consumers put off purchases and wait for prices to fall further, which contributes to even further deflation.
So the Fed announced QE2, which involves printing more money that will be used by the government to buy bonds. Pumping $600 billion into the economy is supposed to stimulate spending.
But more money will also further devalue the weak dollar, making American goods cheaper abroad. While the impact on trade would be welcome, there are already grumblings about a trade war brewing with China, which is taking steps to slow its economy down.
With the purchase of bonds, QE2 was also seen as a way to bring interest rates even lower, even though they are already close to zero.
So how will QE2 turn out?
When plans for QE2 were announced, stock prices rose. On Friday, though – the first day of QE2 – prices dropped. Investors were selling bonds as the government was buying them, canceling the impact of the government’s action to some extent.
We’ll see what happens next, but there is no certainty that QE2 will stimulate inflation (QE1 didn’t). And there is also a chance that it will cause too sharp of an increase in inflation. The current rate of inflation is under 1% and the Fed would like to see inflation rise to 2%.
Note to Fed Chair Ben Bernanke: Be careful what you wish for.