The New Stimulus Package and What it Means for Investors
submitted by Brent Lindell

The Federal Reserve recently announced that it will take further measures to stimulate the economy. Commonly referred to as “QE2” (a second program of quantitative easing), the Fed said it would create or “print’ an additional $600 billion and purchase a wide range of short- and long-term Treasury bonds by June 2011. In addition, the Fed also said it will reinvest the principle on its existing holdings of Treasury and mortgage-backed bonds, adding another $300 billion or so to the program.

The media has clearly latched onto the almost ominous sounding term “QE2,” but what does this really mean for investors and the markets?

What is Quantitative Easing?

When a recession hits, the Federal Reserve has many tools at its disposal to try to stimulate the economy. The most common and widely known tool is to simply lower interest rates. Lower interest rates encourage businesses to make investments while also encouraging banks to lend money for those investments. Theoretically, this will spur economic growth.

In response to the Great Recession in late 2008, the Fed has already cut rates to essentially zero — an unprecedented move. However, the economy and the financial markets continued to worsen. Since the Fed cannot lower rates below zero, it decided to take a more drastic approach to stimulate the economy — this is the Quantitative Easing.

Through Quantitative Easing, the Fed essentially creates or “prints” new dollars and uses them to purchase securities on the open market. In late 2008 and early 2009, the Fed did this extensively and purchased over $1 trillion worth of Treasury and mortgage-backed bonds, which added new cash to the banking system. The intent was for banks to use this flood of new cash to spur new lending and economic activity.

In reality and in retrospect, the banks decided to hoard the majority of this cash, use it to increase their reserves, and fill holes on their balance sheets. So, while this first round of quantitative easing did not spur as much economic growth as the Fed hoped, most economists agree that it did help ease credit conditions enough to prevent deflation and depression. It also succeeded in keeping both Treasury and mortgage rates extremely low, which has been a boost to the challenged housing market.

What Does it Mean for Investors?

Looking at the evidence and what a lot of experts are saying, I’m not sure that the latest round of quantitative easing will have much effect (either positive or negative) on the economy or stock returns. The first round of easing that began in 2008 succeeded in lowering rates and easing credit conditions but did little to encourage growth since banks decided to hoard most of the extra cash. It is likely that banks will decide to do the same thing with QE2 — at least until businesses and consumers become less reluctant to spend.

Here are some other points to keep in mind:

• The Fed has indicated for some time that further quantitative easing was likely, so QE2 is certainly not a surprise. This means that the Fed’s recent announcement was largely already priced into the stock market before the official announcement was made.
• By implementing QE2, it is clear that the Fed is committed to keeping interest rates low in order to promote economic growth. This could remain a challenge for investors who are dependent upon the yield generated by their savings. This is good, however, for potential home buyers and for those who qualify to refinance their mortgage.
• Many investors are worried that the newly “printed” dollars will spark inflation. I think this is unlikely in the short-term. With such high unemployment and so much excess manufacturing capacity, the economy has far too many underutilized resources today for inflation to take hold.
• By “printing” money and essentially creating a larger supply of dollars, QE2 could also negatively impact the U.S. dollar. This is not an entirely bad thing, however. A lower dollar could help boost exports, encourage companies (both domestic and foreign) to move operations and jobs to the U.S., and improve earnings that U.S. companies generate overseas.

The biggest takeaway from QE2 for investors is that the Federal Reserve is committed to fighting recession and deflation. It also demonstrates that the Fed has many tools at its disposal, and is willing to go to fairly extreme measures if needed. Although, the recovery has not been as quick or robust as many hoped for, it is important to note that all signs are continuing to point toward a gradual recovery from an exceptionally deep recession. And, if the economy continues to recover as it has, the Fed will eventually scale back its involvement.

Brent Lindell is with Savant Capital Management, Inc.

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