The inflation hawks are circling, warning of the dire consequences of the Fed's new QE2 scheme. "Quantitative easing" (QE) is Fedspeak for creating money out of nothing with a computer keystroke. The hawks say QE is massively inflationary; that it is responsible for soaring commodity prices here and abroad; that QE2 won't work any better than an earlier scheme called QE1, which was less about stimulating the economy than about saving the banks; and that QE has caused the devaluation of the dollar, which is hurting foreign currencies and driving up prices abroad.
It might be argued, however - and will be argued here - that QE2 not only will NOT produce these dire effects, but that it is NOT actually about saving the banks, OR devaluing the dollar, OR saving the housing market. It is about saving the government from having to raise taxes or cut programs, and saving Americans from the austerity measures crippling the Irish and the Greeks; and for that, it could well be an effective tool. What is increasing commodity and currency prices abroad is not QE, but the US dollar carry trade; and the carry trade is the result of pressure to keep interest rates artificially low to avoid a crippling interest tab on the federal debt. QE2 can relieve that pressure by funding the debt interest free.
The debt has increased by more than 50 percent since 2006, due to a collapsed economy and the decision to bail out the banks. By the end of 2009, the debt was up to $12.3 trillion; but the interest paid on it ($383 billion) was actually less than in 2006 ($406 billion), because interest rates had been pushed to extremely low levels. Interest now eats up nearly half the government's income tax receipts, which are estimated at $899 billion for FY 2010. Of this, $414 billion will go to interest on the federal debt. Raising interest rates just by a couple of percentage points would make income taxes prohibitive.
Interest rates cannot be raised again to reasonable levels until this interest tab is reduced. And, today, that can be done most expeditiously through QE2 - "monetizing" the debt through the government's own central bank. Only its own central bank will advance credit to the government interest free. Congress also has a computer keyboard and could issue the money not just debt free but interest free, but Congress has not been so bold since the Civil War. The Fed has, therefore, had to step in.
