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What Is The Fed Up To?

 If you have been watching the media talking heads recently, there has been much disagreement on whether the US economy is actually recovering or getting worse.

Last week, the Federal Reserve (the Fed) stated that they will be purchasing an additional $600 billion (yes, I said billion) of Treasury securities by mid-2011.

So, if the economy is improving why is the Fed taking this action (which many are calling QE2 -- quantitative easing part 2)? Well, the two biggest reasons are to try to keep the current stock market rally going and to raise the inflation rate.

(The above chart shows how the Fed's balance sheet has become significantly bloated over the past three years due to their attempts at stimulating the economy.) 

By purchasing Treasury securities, i.e. bonds, the Fed is looking to push interest rates lower. These actions are certainly questionable for the the long-term health of the US economy; but good news for short-term market performance. The Fed's actions will make it more attractive for companies with rising stock prices to access capital by issuing stock. The company can then use the proceeds to invest in research and development, thus increasing output which will lead to the need for more hiring.

Corporate growth is becoming a hot topic as research and development (R&D) has declined for the first time in over a decade. The process from R&D to finished product is time consuming. A continued decline in R&D spending means a longer period before companies will look to expand their workforce.

In a recent New York Times article, Robert Gordon from the National Bureau of Economic Research stated that "There is a substantial chance that the US is headed into a lost decade, similar to what Japan has experienced in the past 15 years, possibly with zero inflation instead of actual deflation. But the consequences for the US population will be much more severe than in Japan because of our higher unemployment rate, our lack of a social safety net, our system that ties medical insurance to employment instead of making it a right of citizenship, our great inequality and our higher level of poverty."


While the outcome for the US economy may not be as severe as Mr. Gordon states, these type of articles are read by consumers, small business owners and CEOs. If people are worried about a poor economic outlook, they will not spend, they will not invest in expanding their businesses, and they will not look to hire more employees.

While the long-term effects on the US economy are in question, look for the market to continue rising for the next few months as the Fed pumps $600 billion into our economy.

Disclosure: No Positions