On Thursday the Federal Reserve's Federal Open Market Committee will make a highly anticipated statement that many investors believe will announce the initiation of a third round of quantitative easing. "QE" is a form of monetary stimulus, whereby the Fed purchases securities such as treasury bonds and mortgage-backed securities in an effort to drive down interest rates, and infuse the financial institutions they buy the assets from with more cash. The goal is ostensibly to spur lending in an economy in which credit has tightened since the financial crash in 2008, and also to discourage safe-haven investing in treasuries.
The first round of QE1 was primarily geared toward taking toxic mortgage-backed securities off the balance sheets on the country's major financial institutions. The return on these derivatives relied on the ability of homeowners to make regular payments on their mortgages. But after housing prices collapsed in 2006 and 2007, a wave of defaults rocked the mortgage market and holders of these securities, which were essentially the bundled mortgages of thousands of homeowners, suffered major losses. With the Fed taking on these toxic securities in exchange for cash payments, banks cleaned up their balance sheets.
QE is a controversial approach because of its potentially inflationary nature. When the Fed buys securities from banks, it credits the accounts those banks have with the Fed for the purchase price, which has the effect of increasing the money supply (though money is not literally printed as a result of this, as many believe). Libertarian critics such as Ron Paul say more QE could lead to harmful inflation or hyperinflation, and that QE3 would only succeed in driving stock and commodity prices higher without creating any real growth in the economy. Meanwhile, Keynesian economists such as Paul Krugman welcome additional QE because the pace of the recovery has been slow, and that attempting to loosen credit markets is necessary to drive consumption.
If that still seems obscure, the following video further explains QE.
Should the Federal Reserve enact a third round of monetary stimulus? Is it necessary to help spur lending? Or will it be completely ineffective in freeing credit markets and simply succeed in driving commodities prices, such as food and oil higher?