QE2: What It Is and Why China and the Rest of the World Hate It

The Federal Reserve System has introduced a new program the financial industry calls QE2. It is based on the Fed’s definition of “quantitative easing”. It is designed to bring down interest rates which are already near zero and makes the financial community very nervous.   The Fed’s buying of long term Treasury bonds will push down their yields, and all the interest rates that are tied to these bonds will also suffer.

Investors are not really interested in acquiring more United States’ securities when much better rates are available throughout the world.   The Fed’s credibility is also suffering as it appears they are losing control over their ability to attract investors and protect the United States economy from inflation. As a result of cheap money, emerging market stocks are up over 30%, but emerging market bonds are being driven to new lows.  

The net result of the new commitment to issue $600 billion in dollars created out of thin air is ineffective as the Fed appears to be the primary buyer of the government bonds.   Major credit-worthy companies such as Microsoft, Coca Cola and Wal-Mart are taking advantage of the low interest to refinance their debt depriving bond and other debt holders of income.   The price of the 30 year Treasury bonds has fallen almost 12% since Fed Chairman Ben Bernanke made his announcement of their plans.   He added more fuel to the fire when he said the government would “never” resort to monetizing their debt.  

The truth is that QE2 is just Fedspeak for creating money out of nothing.   Interest rates have to rise to begin to solve the economic problem and this cannot be accomplished when the Fed is charging zero interest to the most credit-worthy borrowers.   So, they resort to printing more money and “monetizing” the already outstanding debt.   President Obama continues to support Bernanke’s policies and nominated him for another term when he should be demanding accountability.   Bernanke’s track record since 2005 has been dismal.   He continually maintains that the United States economy is on “solid footing.”   In 2009, he promised Congress that we would not “monetize” the debt which is exactly what QE2 does.

James Bullard, the President of the Saint Louis Federal Reserve Bank said recently in a presentation to the New York Society of Security Analysts that the policies in the United States should work very hard to avoid the possibility of a Japanese-style deflation.   Japan put in place a similar program with almost zero interest rates and found that it took them over ten years to extract their economy from its effects.

The Bank of Japan now admits that the reduction in their interest rates was a failure.

The Fed is monetizing the debt and China voiced its opposition.   Over the past six months, China has reduced U.S. debt purchase of about $50 billion per month.   Although President Obama is on the offensive against the Yuan and criticizes China for keeping its currency artificially low, this is precisely the strategy announced by the FED with the tacit approval of the White House.

Bill Bonner of Agora Financial said that we are simply financing America’s trip to bankruptcy with the current policies of the Federal Reserve.   In eight months time, the Fed will own more Treasuries than China and Japan combined, making it the largest holder of government securities outside of the government itself.

Foreign observers are waiting to see what tone the newly elected Congress will take with China.   Major investors agree that if China were to stop pegging the Yuan to the dollar, the Yuan would rise dramatically in value.   China’s reserves and monetary policies are among the strongest in the world.  

This is just one of the reasons China hates QE2.   China is currently struggling to control bubbles in real estate and their own stock market.   But the over-riding concerns in China are because they are our largest creditor.   Because the dollar is a reserve currency, most of this debt is dollar-denominated.   China currently holds over 20% of our total debt and they fear greatly the continued printing of more dollars as this can only devalue the dollar and make all commodities more expensive for their citizens.   This could force them to devalue the Yuan which they would much rather do on their own terms and timetable.

China is joined in this displeasure over QE2 by Germany.   The Finance Minister Wolfgang Schauble said the Fed is “clueless” and he is absolutely disgusted by their actions.   Financial leaders in Brazil, Russia and the oil producing countries of the Middle East all are ready to oppose QE2 on every front. Brazil recently raised taxes on foreign investments. The World Bank suggested that Asian economies may need to set their own set of capital controls to prevent the asset bubbles that would result from cheap money flooding out of the United States due to QE2.

We cannot run the risk of all of the countries of the world hating QE2 and refusing to buy our debt but a change of policy from either President Obama or Federal Reserve Chairman Bernanke doesn’t seem likely at this point.   Instead, they are “doubling down” on failed policies which can only lead to the demise of the dollar.  

Can QE3 be far behind?