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Quantitative Easing Round 2 and Deflationary Fears

February 21st, 2011

The following is a guest post from Cesar Zambrano. If you are interested in guest posting at Geek Politics, check out the guidelines here.

The U.S. dollar found few buyers during Q2 and Q3 2010. The reason was simple. Federal Reserve Chairman Ben Bernanke practically sealed the mid-term fate of the U.S. dollar when he began hinting during the summer that the Fed may move forward with a second round of quantitative easing. During the first week of November 2010, the Fed laid all speculation to rest when it formally announced it would move forward with a second round of quantitative easing, to the tune of $600 billion. In this article, we are going to discuss the effect of QE2 on the U.S. economy, and what factors continue to put pressure on prices.

Currency Values and QE

As a general rule of thumb, currency values get crushed when a central bank engages in quantitative easing. In normal circumstances, if a central bank needs to stimulate economic growth in a country, it simply lowers interest rates, which increases the money supply and infuses cash into the real economy. The ripple effect occurs when people borrow this increased cash, banks lend it, and the economy sputters back to life. That, however, is in normal market conditions. What we have right now in the United States is far from normal.

The Fed lowered the short-term interest rate target to near 0% back in 2008, but the economy has struggled to regain strong traction and growth. Thus, when a central bank has exhausted its options in regards to interest rate movements, it can still engage in what is known as quantitative easing. The goal of will be encouraged to lend money to folks seeking small business loans, car loans, mortgages, etc.

Criticisms of Quantitative Easing

QE is quite a polarizing concept. Many critics view it as a complete manipulation of a country’s currency. This, in fact, is exactly what many critics cried when the Fed announced it would move forward with QE2. Leaders from Germany, France, China, and most emerging market countries publicly attacked the Federal Reserve’s decision, calling it irresponsible. When QE is initiated, it causes a huge excess of liquidity, and opponents of QE2 were concerned this excess liquidity would flood into emerging market economies that were already under inflationary pressure and who were already facing rising exchange rates in foreign exchange trading. Although the complete impact on these emerging market countries is hard to gauge because QE2 was just initiated a few months ago, their argument carries substance.

Core Inflation and QE2

The primary reason the Federal Reserve moved forward with QE2 was because prices were falling well below target levels and it appeared that deflation could begin to settle into the U.S. economy. A deflationary environment is recognized by economists as devastatingly difficult to escape. Currently, 3 months after the initiation of QE2, inflationary data is beginning to show upside movement. This means that deflationary fears are calming. The effect of QE2 on U.S. dollar value can be tracked on a forex demo account.

In February 2011, Core Consumer Price Index (a major gauge of inflation) rose 0.2% above the January figure. This was the largest single month increase in over a year, and it was well ahead of market expectations. This positive figure reinforces the notion that deflationary fears are currently being pushed back, but risk still remains. The labor market is still very weak in the U.S., with unemployment staying around 9%, and this high level of unemployment will continue to put pressure on prices.

Author: Derek Clark Categories: Finance Tags: