Federal Reserve: Quantitative Easing 2 Is A Dangerous Game

| November 5, 2010 | 0 Comments

In the classic 1955 film, Rebel Without A Cause, 17-year old Jim Stark (played by James Dean) is pressured into playing a high-stakes game to resolve a dispute with school bully, Buzz Gunderson (played by Corey Allen).  After Jim triumphs over Buzz in a knife fight, Buzz tries to regain his pride by challenging Jim to a “Chickie Run”.

A Chickie Run involves the two boys racing stolen cars towards an abyss. The one who jumps out of the car first is deemed a “chicken” or coward.

Apparently, being called a chicken in 1955 was a tremendous insult.

However, the game ends in tragedy when a strap on Buzz’s leather jacket gets caught on the car door.  Unable to jump out of the car, Buzz goes over the cliff to his doom.

At least he wasn’t a chicken!

Certain events this week reminded me of James Dean’s famous Chickie Run.  Of course, I’m referring to the much talked about second round of Fed quantitative easing.

Also known as QE2.

For weeks, investors have been speculating about what the Fed is going to do with monetary policy given the sluggish economic recovery.  With interest rates already at near-zero, the Fed’s most basic tool – raising or lowering short-term interest rates – was no longer useful.

This left the Fed’s next favorite weapon – quantitative easing – as the only viable option.  Quantitative easing is a fancy economic term describing the Fed’s practice of printing dollars to buy U.S. Treasury debt.  And it’s a very dangerous move to make.

Here’s how it works…

By buying Treasuries, the Fed injects dollars (or liquidity) into the monetary system while simultaneously reducing the supply of Treasury debt.  The net effect is more money for banks to create lending and a depressing of yields paid on Treasuries.

The belief is quantitative easing will stimulate banks to lend out more money and make it cheaper for companies to raise capital.  Companies will then use this capital to grow their businesses.  And ultimately the nation’s rate of economic growth will increase significantly.

Sounds great right?

The only problem is there’s a huge potential downside risk…

The policy could be more effective than intended.

If the Fed injects too many dollars or continues the policy for too long, it could spark hyperinflation – very high or out of control inflation. Hyperinflation usually leads to severe economic depressions.

In periods of hyperinflation, prices of ordinary goods and services rise 5%, 10%, or more every day!  Can you imagine what would happen if prices of food and gas were doubling every two to three weeks?

Despite this astonishing risk, the Fed announced this week a second round of quantitative easing.

They’re going to buy $600 billion more of Treasury debt.  What makes this a risky bet is it comes after a huge buying spree in 2009.  Last year, the Fed bought $300 billion of Treasury debt, $150 billion of Fannie Mae and Freddie Mac debt, and $1.1 trillion of mortgage backed securities.

As you can see, the Fed has already injected a huge amount of money into the system.  If QE2 is not handled properly, it could very well spark runaway inflation and send our economy into a nasty downward spiral.

Like the “Chickie Run”, the key to quantitative easing is the exit.  If the Fed waits too long, we’ll all end up going over the cliff together.

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Category: Bonds

About the Author ()

Robert Morris is the editor of Penny Stock All-Stars, an investment advisory focused on discovering small-cap and micro-cap stocks that are destined to become the market’s next Blue Chips. The Wall Street veteran and small-cap stock specialist is also a regular contributor to Penny Stock Research. Every week, Robert shares his thoughts with our readers on a variety of penny stock-related topics. In addition to Penny Stock Research, Robert also writes frequently for two other free financial e-letters, ETF Trading Research and the Dynamic Wealth Report. He’s also the editor of two highly successful and popular investment advisories, Biotech SuperTrader and China Stock Insider.

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