In September, Ben Bernanke announced that the Federal Reserve would be extending its bond buying program in the form of a third round of quantitative easing (QE3). QE is an unconventional form of monetary policy enacted by central banks if conventional monetary policy is not effective. It amounts to, basically, the creation of a pre-determined amount of new money, which is injected into the economy by the Federal Reserve's bond purchases.
QE has the effect of increasing bank reserves, as well as driving up prices on bonds and lowering their interest yield. So far, it has been an effective method for the Federal Reserve to boost financial markets. Each time it has been enacted, we have see stock prices increase.
Some say that QE is a necessity to stave off deflation, which would manifest in plummeting prices. As long as stock prices and home values are kept high, QE's proponents reason, people will be encouraged to spend money and stimulate economic growth. This does not mean that QE is the cure-all to America's economic woes. In fact, it is anything but a panacea; rather, it is prolonging the fundamental problems that underlie the United States' economy.
The most glaringly visible problem is home prices. QE's proponents believe that keeping home values high will lead to more consumer confidence, since their high home equity values will lead them to feel secure when spending their money. While this is true, it merely means that these interventions in the market are duping consumers into believing that they have more than they actually do.
During the housing boom, many more houses were built than there currently is a demand for. 11.4% of all homes in the United States are vacant — there are more empty homes in this country than homeless people. Despite the fact that this statistic includes second homes which are not primary residences, it reveals an obvious fact: Many foreclosed homes that are now empty are overpriced. People cannot afford to buy them. Why?
When the Federal Reserve is buying $40 billion (created out of thin air) in mortgage-backed securities, it is no wonder that home prices are being artificially bolstered. In literal terms, the Fed is trying to re-inflate the burst housing bubble which caused the crisis in 2007-08. Even an economic layman can tell that this is a bad idea.
In essence, the policy Bernanke has prescribed consists of giving the American economy more of the drug it is addicted to: cheap money. As a consequence, rather than correcting itself at a much lower value than at the peak of its book, housing prices remain high. While this may create economic activity in the short-term, it will be devastating in the long-term. The same is true of some stocks whose values are increased by this activity.
Coupling this with the inflation risk of dumping tens of billions of fresh new dollars into the economy, it is clear that the Fed's policy has its pitfalls. Either way, it seems that Americans are bound to undergo financial woes. On one hand, Americans can continue the addiction that started this mess. On the other, Americans can start the withdrawal now, with the only comfort being that it could have been worse later.
Unfortunately, it seems that the Fed has picked the first option for us.