QE2, the Federal Reserve’s program to buy an additional $600 billion of Treasuries (along with an estimated $200 to $300 billion in re-investment of maturing securities), should be far more effective than QE1 because this latest installment of Quantitative Easing will ultimately create what the original program did not: velocity of money.
With QE1, the Fed's newly printed dollars were used (for the most part) to purchase illiquid assets such as mortgage backed securities from the large commercial banks. Whether by choice or not, the cash received for these securities is being held on deposit at the Federal Reserve Banks (i.e. the Fed bought assets from the large commercial lenders who are just keeping that cash at the Fed).
You can see this by looking at the Fed's balance sheet (the weekly H.4.1 report). As of November 4, term and other deposits held by depository institutions at all Federal Reserve Banks was still nearly $988 billion, down just $77.3 billion from one year ago. In normal times, this number varies between $8 and $14 billion or so.
We can speculate on the reasons why the large lenders are keeping their powder dry at the Fed. For one thing, the banks are still reluctant to lend. Also, the deposits are receiving 0.25% interest. Another possibility might have to do with the ultimate disposition of all this paper; while not repo agreements, the Fed likely does not envision holding these assets to maturity (and it may want to sell them relatively quickly if and when the need comes to tighten policy), which means that the door to the banks buying these assets back is probably still open, especially since the cash to do so is readily available.
What all of this means, however, is that in essence, QE1 created very little velocity of money because the cash created in the first program is not moving through the system. For whatever reason, a large percentage of QE1 cash is doing nothing more than sitting at the Fed collecting 0.25%.
With QE2, the Fed is not buying an illiquid asset from a bank; what they are buying is an extremely liquid asset from its dealers, and they are doing so with newly created money. The fact that Treasuries are totally liquid means that the Fed's new QE2 money will circulate into the system and do a far better job at creating money velocity than the cash used for QE1 as long as the following condition is met (which it will be):
To simplify things, let's say we have 2 bidders at a Treasury auction, each with $100 billion to spend. Along comes the Fed with $100 billion that it just printed and buys all the Treasuries at that particular auction. The 2 bidders that got shut out are not going to keep that cash in their pockets; it is a virtual certainty that they are going to buy something else, especially because speculation is rampant that the dollar is going to be depreciating due to the Fed’s actions. So, what these bidders will do is buy Treasuries in the secondary market, if that's what they want. They can also buy stocks, which is what I am sure the Fed is hoping they will do. They can get into commodities and help to create some inflation (which is also what the Fed wants). Or gold. Or whatever they want.
So now, you have $100 billion x 3 in the system, not $100 billion x 2, because the Fed's money is newly printed money and because the 2 buyers that were shut out at the auction will not be staying in cash. But what is essential is that the dealers who sold the Fed its Treasuries have no reason to hold that money at the Federal Reserve Banks (as the large depositories are doing), because they have no need to hold reserves.
In other words, the Fed will not need its dealers to hold cash because when the time comes to tighten policy (selling Treasuires back to its dealers in order to drain cash from the system), the dealers will be able to buy whatever amount the Fed requires them to as the secondary market into which they can off-load their inventory is extremely deep and liquid (unlike the market for mortgage backed securities).
So, it is likely that dealers are going to do what dealers do-circulate the money received from the Fed, money that otherwise would not have been there because it is newly created, thereby generating what QE1 did not: velocity of money. But that is not all.
The Zero Hedge blog came to an interesting conclusion vis a vis what the Fed's primary dealers do with the cash by analyzing the Permanent Open Market Operations of the Federal Reserve Board of New York.
According to ZH:
The same primary dealers who were the benefactors of the Fed’s guaranteed UST bid instead used the end of quarter, FRBNY-facilitated window dressing to not only not offload coupons, but to dump everything else, and use the proceeds to buy stocks thereby explaining both the massive ramp into the end of September, and also the ongoing attempt to flush NYSE shorts.
Now, how much of an effect this will ultimately have on the real economy is certainly open to debate (in nominal terms, if the Fed gets to $900 billion by June 2011, it will have added 6.11% in cash relative to 3rd quarter 2010 GDP). It could very well turn out that, much as the stimulus, the initial $900 billion of new purchases and rollovers will be too small to have the desired effect. But the FOMC has left the door open to doing more and with Mr. Bernanke at the helm, there should be little doubt that additional Quantitative Easing will occur should conditions warrant.
However, it is my opinion that over time, what we can expect to see is the economy growing faster than it otherwise would have, which means that stocks and commodities should continue to do well as the dollar depreciates.
Disclosure: Long the dollar for now, but planning to get short again as the weak dollar trend resumes.
