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The FED's Big Gamble


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The Fed's big gamble: Here's what could go wrong

The Federal Reserve launches plan to lift all boats. Who knows how it will play out?

The Federal Reserve is making a high-stakes bet in the hope of getting the economy steaming along again. Nobody is sure the Fed's best efforts will work, and they may actually backfire.

The Fed announced a plan to buy $600 billion in government debt, aimed at driving already low long-term interest rates even lower. The central bank would buy the debt in chunks of $75 billion a month through June of next year.

Economists call it "quantitative easing." The latest package gets the name "QE2" -- like the ship -- because it's the second round. The Fed spent about $1.7 trillion from 2008 to earlier this year to take bonds off the hands of banks and stabilize them.

Here's how it's supposed to work this time: The Fed buys Treasury bonds from banks, providing them cash to lend to customers. Buying so many bonds also lowers interest rates because demand for Treasurys leads to higher prices and lower yields. Interest rates on consumer loans are tied to Treasury yields. Lower rates entice people to take out a mortgage or another loan.

At the same time, lower interest rates make relatively safe investments like bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, like stocks. The S&P 500 takes off and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues.

But many analysts and even supporters of the plan see dangers. It could make the weak dollar even weaker and lead to trade disputes with other countries. It could lead bond traders to believe that inflation will run wild, and they derail the Fed's efforts by pushing rates higher. Many investors argue that it may create bubbles as hedge funds and other speculators borrow cheaply and make even bigger bets on stocks, commodities and markets in developing countries like Brazil.

"It's a desperate act," says Jeremy Grantham, co-founder of the investment firm GMO. Grantham says it's a clear message from the Fed to the rest of the world: "The U.S. doesn't care if the dollar weakens."

Here is a look at two ways the Fed's strategy could go wrong:

--DOLLAR DROP

As word trickled out over recent months that the Fed was planning a new round of bond purchases, the dollar sank. It hit a 15-year low to the Japanese yen Nov. 1. Why? In the simplest terms, a country that cuts interest rates makes its currency less attractive to the worlds' investors. The interest rate is also the investors' yield, the payout they receive. When that yield falls, the world's banks move their money into countries with higher rates. They may exchange U.S. dollars for Australian dollars then invest the money in higher-paying Australian bonds.

"The Fed aims to push up the prices of stocks, bonds, real estate, and you name it," says Bill O'Donnell, head of U.S. government bond strategy at the Royal Bank of Scotland. "Everything is going to go up but the dollar."

A drop in the dollar can help companies like Ford that sell their products abroad. When the dollar weakens against the euro, for example, one euro buys more dollars than before. Foreign customers notice the price of the Explorer they've been eyeing is lower in their currency, yet Ford still pockets the same number of dollars for every sale.

The downside is that a weakened dollar pinches people in the U.S. because anything produced in other countries becomes more expensive, like oranges from Spain or toys from China.

"Look around you," says Thomas Atteberry, a fund manager at First Pacific Advisors. "How many things can you find that were made in the U.S.A?"

--BLOWING BUBBLES

Buying bundles of Treasurys knocks down interest rates, making borrowing cheap. But it also motivates investors to move out of safe investments into riskier ones in search of better returns. The stock market, for instance, rises in value and everyone with savings in stocks feels wealthier. Ideally, it produces what economists call a "wealth effect": People who feel better off spend more.

The problem, according to some critics, is that cheap borrowing costs and buoyant markets make a fertile environment for bubbles, which eventually pop. "The effort to help the economy sets up another more dangerous bubble," says Grantham, who warned of Japan's surging real estate and stock markets in the 1980s, soaring Internet stocks in the 1990s and the housing market in the 2000s.

Stocks in developing countries are a likely candidate for the next bubble. Cash from Europe and the U.S. has plowed into emerging markets, such as Brazil and Chile, since the financial crisis, largely because these countries have less debt and faster economic growth than in the developed world.

Another concern: Hedge funds borrowing cheap money can magnify their bets, taking a loan at 2 percent to buy a security that's rising 10 percent. They sell the security, pay off the bank and pocket the rest. That's true whenever interest rates remain low. Falling rates allow speculators to borrow larger amounts. In the extreme, losses from hedge funds and other borrowers can put their banks at risk and leave governments to clean up the mess.

The game only works as long as the investment keeps climbing. When the bubble breaks, the fallout can devastate an economy.

"I think bubbles are the main villain in this piece," Grantham says.

Cheap debt provided the fuel for the housing bubble, allowing home buyers to take out larger loans on the belief that somebody else would buy the house at a higher price. Fed chief Ben Bernanke's answer, Grantham said, is to start the cycle over again by blowing a new bubble. "All they can do is replace one bubble with another one," he said.

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I think some of the problem here is that The Fed and Government are under the impression that they always have to do something.

What do you expect when the country screams and cries any time they can't have more stuff?

We have a nation of people who are obese and diabetic, yet they want insurance, a socialized form of health care, to cover the limitless cost of their excess...all the while screaming and yelling about how terrible socialism is. We have a nation of people who want to government to 'DO SOMETHING' anytime something goes wrong, yet talk endlessly about how little they want government. A nation of people who live their lives under the freedom, safety and protection provided by the very same government they claim has ruined our lives.

We're the 3 year old baby of countries. All we do is whine and complain, scream and yell and point fingers, all with very little context (Taxed Enough Already? Look at historical marginal rates!) or education for our behavior.

You'd have to drag me kicking and screaming into government. Why would anyone want to serve this nation of babies?

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What do you expect when the country screams and cries any time they can't have more stuff?

We have a nation of people who are obese and diabetic, yet they want insurance, a socialized form of health care, to cover the limitless cost of their excess...all the while screaming and yelling about how terrible socialism is. We have a nation of people who want to government to 'DO SOMETHING' anytime something goes wrong, yet talk endlessly about how little they want government. A nation of people who live their lives under the freedom, safety and protection provided by the very same government they claim has ruined our lives.

We're the 3 year old baby of countries. All we do is whine and complain, scream and yell and point fingers, all with very little context (Taxed Enough Already? Look at historical marginal rates!) or education for our behavior.

You'd have to drag me kicking and screaming into government. Why would anyone want to serve this nation of babies?

Before you go calling us a nation of babies, take a look at the much older countries in Europe. (I.E Greece, France.)

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Before you go calling us a nation of babies, take a look at the much older countries in Europe. (I.E Greece, France.)

I don't live in France or Greece, and I don't have to listen to their whining about retiring at 62 after a life spent taking naps and drinking coffee for work, so it's not really my concern. But yes, they certainly qualify.
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What do you expect when the country screams and cries any time they can't have more stuff?

We have a nation of people who are obese and diabetic, yet they want insurance, a socialized form of health care, to cover the limitless cost of their excess...all the while screaming and yelling about how terrible socialism is. We have a nation of people who want to government to 'DO SOMETHING' anytime something goes wrong, yet talk endlessly about how little they want government. A nation of people who live their lives under the freedom, safety and protection provided by the very same government they claim has ruined our lives.

We're the 3 year old baby of countries. All we do is whine and complain, scream and yell and point fingers, all with very little context (Taxed Enough Already? Look at historical marginal rates!) or education for our behavior.

You'd have to drag me kicking and screaming into government. Why would anyone want to serve this nation of babies?

I expect people that have been elected into leadership roles to act as leaders. What do you expect of them?

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I expect people that have been elected into leadership roles to act as leaders. What do you expect of them?

They're elected to represent the constituents, not 'lead'. And representing the American people at this point in time is a fool's errand.

Dems and Reps both avoided the subprime crisis because it brought huge GDP growth, and Americans loved it. Everyone was happy. Then, it all came crashing down and Americans said 'How could YOU let this happen'. We then turn around and put the world's weight of pressure on elected officials to bring back huge GDP growth. It's ridiculous.

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They're elected to represent the constituents, not 'lead'. And representing the American people at this point in time is a fool's errand.

Dems and Reps both avoided the subprime crisis because it brought huge GDP growth, and Americans loved it. Everyone was happy. Then, it all came crashing down and Americans said 'How could YOU let this happen'. We then turn around and put the world's weight of pressure on elected officials to bring back huge GDP growth. It's ridiculous.

It is all ridiculous. But we don't elect members of The Fed do we? And I'd have to add that the higher level the elected official, the less representing of constituents there is. Especially with appointments...

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They're elected to represent the constituents, not 'lead'. And representing the American people at this point in time is a fool's errand.

Dems and Reps both avoided the subprime crisis because it brought huge GDP growth, and Americans loved it. Everyone was happy. Then, it all came crashing down and Americans said 'How could YOU let this happen'. We then turn around and put the world's weight of pressure on elected officials to bring back huge GDP growth. It's ridiculous.

I agree with a lot of what you're saying in this thread, but I think you're speaking of a smaller portion of the American public than you think. Most people are results oriented when it comes to politics. They want peace and prosperity and a government that solves national problems when they arise. Everything else is just chatter that distracts them from their real lives.

Because they're results oriented, most Americans don't care much about the messy details of policy debates. They don't want huge spending and deficits but they do want government to solve some of their problems like health care.

The reason people look like they're schizophrenic is because things are universally bad right now. Things got bad under Bush so they blamed Republicans. They voted for Democrats (to the extent that they bothered voting at all) to fix things. Things stayed bad under Democrats--the economy hasn't recovered, the deficit has exploded, and they don't really know what happened with health care. So now they're angry with Democrats.

When things turn around in the economy, the public is going to be happy again and they're going to reward whoever they think is responsible. It doesn't matter if that happened in response to supply side economics or Keynesian economics or some other set of policies. The real problem with politics right now is the apparent inability of politicians to actually solve problems by passing strong policies.

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I agree with a lot of what you're saying in this thread, but I think you're speaking of a smaller portion of the American public than you think.........

They want peace and prosperity and a government that solves national problems when they arise. ........

They don't want huge spending and deficits but they do want government to solve some of their problems like health care........

They voted for Democrats [/bto fix things. .......

The real problem with politics right now is the apparent inability of politicians to actually solve problems by passing strong policies.

As long as people see "others" as responsible for them this will continue. Until we see ourselves as "free" we will never take this responsibility and the cycle will continue.

Is it any wonder they have us battling to death on a football forum chat board over the minutia of policy?

For every 100 people hacking at the branches of the problem, 1 is hacking at the roots.

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Before you go calling us a nation of babies, take a look at the much older countries in Europe. (I.E Greece, France.)

As a German, I am utterly disgusted by those countries and if I would be sitting in the same boat with the US, I would be disgusted by the economic plans of the US government as well. Instead of becomig more competetive against all those rising countries from Asia and South America, people want to work less, spend more and get more services from their central government. But hey, I am not complaining, buy more VWs and BMWs with the money you don´t actually own! ;)

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