QE2: Fed to buy more debt in attempt to push economy forward

November 03rd, 2010

Evidently long term interest rates are not low enough, at least in the eyes of the Federal Reserve. Stating a sluggish economy that has been slow to recover jobs and expand the Fed today announced a $600 billion spending plan. Will it work? Will the plan lead to lower rates for mortgages? Will you soon be plugging lower mortgage rates into mortgage calculators? That is the debate on Wall Street and abroad in the wake of the Fed’s announcement.

The background

When the credit crisis hit the U.S. economy with its full force in late 2008 the Federal Reserve began buying U.S. Treasury debt, short and long term bills and bonds, to push money into the system and keep interest rates from climbing. Expanding from Treasuries to mortgages, from December 2008 through March 2010 the Fed purchased over $1.75 trillion in long term bond debt.

The primary purpose of the huge bond buying program was to keep money flowing into the economy and keep interest rates low to encourage borrowing by consumers and businesses. At least with respect to interest rates, that strategy certainly worked in the housing markets, as those who have been using refinance calculators can attest. Mortgage rates dropped throughout 2009 and 2010, hitting all-time lows a few weeks ago as measured by Freddie Mac’s weekly Mortgage Market Survey.

Does QE work?

The bond buying program is known as “quantitative easing,” or QE in the headlines. It is the Fed’s alternative to simply printing more $100, $50 and $20 bills and putting them into the economy, which could lead to runaway inflation. The idea behind QE is that purchasing more bonds will put more dollars into circulation, which will generate more consumer and business spending, which will get the economy growing again.

Unfortunately despite the massive effort by the Fed to accumulate long term debt the economy has not responded as expected. Worried that inflation remains well below its targeted level of 1.75 to 2.00 percent, the Fed is hoping that pumping an additional $600 billion of new money into the economy will generate the spending and borrowing that the initial QE, or quantitative easing did not. Naturally, the new plan is known on Wall Street and in the media as “QE2.”

A little inflation can be a good thing

With unemployment stuck above 9.5 percent, and the economy losing steam and growing at less than 2 percent through the third quarter, the Fed is not concerned about inflation from its actions. Actually, it is hoping its actions will lead to at least some inflation.

The estimated impact on the original QE program is a drop of about one-half of one percent in long term interest rates and a collapse of the large spread between U.S. Treasury rates and long term mortgage rates. Mortgage calculators have helped many potential homeowners looking for new home loans and current homeowners looking for refinance mortgages see the benefit the lower rates have had for them as a result of the initial Quantitative Easing. What is unknown is if current users of prequalification calculators and refinance calculators will see similar benefits from QE2.

The Fed’s latest plan

Over the next eight months the Federal Reserve will purchase $600 billion in U.S. Treasury bonds with a maturity of 1.5 to 30 years. The holding period for the Treasuries is estimated to be approximately 5 years; meaning once purchased the Fed will not immediately turn around and auction off their holdings, which would push rates up. During this period the Fed will reinvest revenue from mortgages it currently holds from the initial QE purchasing program to purchase more Treasury debt, estimated to be $250-300 billion more in purchases.

If all goes according to the Fed’s plan the extra money in the system will help push the economy to recovery. Banks will lend, businesses will borrow, jobs will be created and consumers will spend.

What could go wrong

Critics fear that if all goes too well such a cycle may present too much inflation too fast to our economy and because of the nature of the Fed’s holdings, and the amount, slowing down the growth may be incredibly difficult. The negative result critics fear is an economy with runaway inflation the Fed will not be able to control. Such a scenario would lead to dramatically higher consumer prices as well as higher interest rates throughout the economy, including mortgage rates.

Will the Fed’s latest Quantitative Easing policy work? There are plenty on both sides of the answer. We will not know for sure for many months, perhaps a year or more. In the meantime mortgage rates are at all-time lows, home values are relatively stable in most housing markets and now is a great time to use mortgage calculators to determine how you can benefit.

Posted By :
Dennis C. Smith is co-owner and broker of record for Stratis Financial in southern California. He has over twenty years' experience in the mortgage industry.

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