November 4, 2010

Fed’s QE2 Plan Looks to Create Inflation and Drive Dollar Lower

Krasney: 'The Fed is walking a tightrope'

Now that the Federal Reserve’s policy makers have decided to print more money and buy $600 billion of government debt, market watchers are looking closely at what will happen to the U.S. dollar.

The Federal Open Market Committee (FOMC) voted Wednesday to buy $600 billion of longer-term Treasury securities by the end of second-quarter 2011, and the Fed’s intent is to create an inflationary environment by flooding the economy with new money.

If inflation happens, the economy will get a positive jolt of business activity and job creation. That, in turn, should make the dollar cheaper and reduce the cost of goods exported from the United States.

It’s a balancing act, according to Jonathan Krasney, a fixed-income specialist at Krasney Financial in New Jersey and Florida.

“The question is whether $600 billion is going to achieve the desired result,” Krasney said in a phone interview minutes after the FOMC announcement. “The Fed is walking a tightrope. One side of the tightrope is monetizing the debt and driving long-term interest rates down, which would theoretically have the impact of making money less expensive to small and large businesses and homeowners who could refinance.”

But the other side of that is fear of inflation, he said.

“The concern is that by in effect printing $600 billion to go into the system, the Fed is cheapening the value of the dollar,” Krasney said. “Theoretically, they’re going to aid exports from the U.S., but it’s a tightrope.”

To be sure, the Fed is aware of inflation fears—and the effect of its actions on the global currency markets.

“My view is that this is more about currency levels than trying to directly stimulate the economy through an increase in buying Treasury debt,” said Ben Warwick, chief investment officer of Quantitative Equity Strategies in Denver, also interviewed just after the FOMC announcement.

In looking at GDP numbers from the last couple of quarters, the biggest drag has been the trade deficit, especially in Asia, Warwick pointed out.

“That’s being driven by currencies,” he said. “A few years back, the Chinese devalued their currency by 50% in one day, and it obviously helped them on the trade deficit side. Japanese people are now concerned about the yen going up because that hurts their trade surplus, and if the dollar goes down it would be good. It would stimulate GDP, but the $600 billion would only give a quarter of a percentage point extra directly to GDP growth. The currency side would give 10 times that amount potentially.”

In Europe and the U.K., on Thursday the European Central Bank and the Bank of England followed the FOMC’s policy announcement by leaving their interest rates unchanged. The British pound rose against the dollar after the interest rate announcement.

Read about the FOMC’s Nov. 3 announcement at AdvisorOne.com.

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