As QE2 Ends, Will the U.S. Economy Sink or Swim in Its Wake?

Author: Mendoza College

One week from today, QE2 -- the moniker for the Federal Reserve's controversial bond-purchase program -- will end its seven-month voyage. The question now, say economists, is how far and fast the program's conclusion will impact the U.S. economy.

Ben Bernanke, chairman of the Federal Reserve, spoke at a press conference yesterday after the latest meeting of the Federal Open Market Committee (FOMC). Bernanke confirmed the end of QE2, and he confirmed there will not be a QE3 program -- even as the Federal Reserve reduced its economic growth forecasts for 2011 and 2012.

The idea behind the Quantitative Easing program, launched by the Fed in November 2011, was simple enough: The Federal Reserve, would buy up to $600 billion in U.S. Treasury bonds. To do this, it would have to essentially print money, thus injecting liquidity into the U.S. economy.

While the process of executing QE2 was simple, its underlying goals were more complex. Like the first QE program that ran between December 2008 and March 2010, the primary goal was to boost the economy. QE1 did that with a much larger scope, purchasing $300 billion in Treasury securities, $175 billion in agency bonds, and $1.75 trillion -- that's with a T -- of mortgage-backed securities (the bad paper in which we all got an unwelcome education back in 2008).

Compared to QE1, QE2 was smaller in scope, but still tricky to navigate. That's because anytime the government prints money, you run the risk of inflation. The Federal Reserve had to balance the need to boost the economy versus driving up inflation rates.

The effects of QE2 have been arguably mixed -- which is why economists aren't sure exactly what will happen when the program officially ends on June 30.

Here's how QE2 was supposed to work: When governments print money, interest rates are supposed to drop because the Fed makes it cheaper to borrow dollars. Interest rates did indeed decline, which was good news for small businesses because loan and mortgage rates (if a business could obtain such loans) stayed low.

The downside of all the new greenbacks? More money for the same number of services and goods means prices will go up. The Fed would argue that a little inflation would be a good thing, since there were signs last year that despite QE1 and other programs, deflation was still a real risk. 

Deflation may sound good if you're shopping at the grocery store. But if you own the grocery store or all of the farms and factories that supply the grocery store? Not so much. Lower revenues mean cutbacks and layoffs, thus sending the economy into a downward spiral.

Another effect of QE2 was the weakening of the U.S. dollar, because boosting the supply of a currency makes it cheaper to buy. In principle, a weaker dollar makes our exports cheaper and more attractive to overseas markets. Of course, our weaker dollar also means we buy less goods to import, something in which our partners in the global economy were less than thrilled.

Indeed, this may be why the end of QE2 was so well-defined, instead of open-ended like these programs usually are. The Fed needed to reassure U.S. trading partners that this plan was not going to become some sort of status quo in the world markets.

When Bernanke announced QE2 in November, here's what he predicted the effects of QE2 would be:

"Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion," Bernanke wrote in a Washington Post op-ed.

So, based on these goals, did QE2 work? It depends on which of these predictions you examine. The S&P 500 rose eight percent and consumer wealth did rise as well, though both factors showed signs of slowing this spring. The same holds true for consumer confidence, which spiked in 2010 then dropped back to more pessimistic levels this year.

Then there were outright misses for QE2: consumer spending went from a 3.2 percent annual rate to its current two percent rate. Disposable income was rising at 0.8 percent in November, and now its only going up at 0.6 percent.

Bernanke is well aware of the shortcomings of QE2, and in Wednesday's press conference admitted he didn't have "a precise reason" why the recovery has been so slow.

In the face of such a wishy-washy performance, it's a little hard to predict the effects of QE2's end. Here's what will likely be the most immediate impacting events on your business.

Most economists agree that the equities markets, which reacted well to the inception of QE2, will definitely correct themselves. The question is how much. Estimates have been around a 25 percent drop in the stock market over the next six months, though some think the drop will be much harder and faster due to other pressures on the markets, while some economists think that stock owners will be slower to switch to bonds and other commodities.

Bond yields will definitely rise (indeed, they've been slowly rising, another sign QE2 wasn't all that it was cracked up to be), which means interest rates will go up, too. Yesterday the FOMC reiterated that the prime interest rates will continue to stay in the 0-0.25 percent range into next year, so that will keep those rates in check. Still, its going to be more expensive to borrow.

Finally, without all the extra money being printed, the US dollar will strengthen. Manufacturers will feel the pinch, since their goods will be harder to sell overseas, but retailers will have more buying power for imported goods--the mixed blessing when the dollar strengthens.

The overall trend in all the guesswork about the end of QE2 is that there are few economists and pundits who think there will be a massive sell-off in the markets come July 1, so don't look for a panic next week.

The final docking of QE2 will remove some economic stop-gaps, true, but given the less-than-stellar effect of the program in the first place, its absence may not be so keenly felt, either.