Why the Federal Reserve's Quantitative Easing Strategy Won't Save the US Economy

[Editor's Note: Retired hedge-fund manager Shah Gilani is one of the industry's foremost experts on the global financial crisis – and all the worldwide ripple effects that this financial scandal has caused.]

With a second round of "quantitative easing" underway, the U.S. Federal Reserve wants us to believe that it is doing its duty as the nation's central bank – promoting maximum employment, keeping a lid on inflation and making sure that long-term interest rates remain at reasonable levels.

This is known as the Fed's "dual mandate," since the inflation and interest-rate objectives are really the same goal.

But here's a shocker: The Federal Reserve's real dual mandate is to enrich the banks the central bank is created by and works for – and to cover Congress when its laws enrich banks at the expense of jobless American taxpayers.

Understanding how quantitative easing works is simple. Understanding how banks and Congress are manipulating this economic tool is just a tad more complicated. Understanding how quantitative easing will impact your life – and your financial future – is just a matter of understanding the facts

Quantitative Easing Basics

The mechanics of quantitative easing are straightforward. For instance, the Federal Reserve can decide to lower interest rates for any number of reasons, but it's usually to encourage borrowing and consumption to stimulate the economy.

When the Fed decides to lower rates, it does so by reducing the so-called "Fed Funds" rate – the rate banks charge each other for overnight loans.

The Fed doesn't just say what it wants the Fed Funds rate to be. Through what's known as "open-market operations," the Fed actually lowers the rate to its target by purchasing U.S. Treasury securities from banks. The cash the banks receive in return can then be lent out.

And when a lot of banks have money to lend, there is usually a general decline in the overall level of interest rates in the broader marketplace.

Right now – because the Fed keeps purchasing short-term government securities – the Fed Funds rate is at roughly 0.00% to 0.25% (about one-quarter of 1.00%). This time around, however, low marketplace interest rates haven't been enough to stimulate the economy and generate reasonable growth. And those historically low rates have done nothing to bring down the high rate of unemployment.

So, to further stimulate the economy and encourage employment and prevent deflation (falling prices) the Fed is employing a second round of quantitative easing – a move the pundits refer to as "QE2," or even "QEII."

Regardless of what you call it, the maneuver simply means the central bank is buying still more government securities, focusing this time on those with longer-term maturities.

The Skinny on the Central Bank

The Fed doesn't actually "print" money to buy any of these securities. Only the U.S. Treasury Department can print money through the U.S. Bureau of Engraving and Printing that it controls (Indeed, the Bureau of Engraving's Web site address is most appropriate: http://www.moneyfactory.gov/).

The Fed pays for the securities it buys by electronically crediting the accounts of the primary dealers that sell the central bank U.S. Treasury bills, notes and bonds. The "credits" are passed along to the primary dealers' customers (other banks, securities broker-dealers, and financial institutions) who buy and sell their inventory to the Fed through the primary dealers.

So, while the Fed doesn't actually print money, it does create money – thanks to the credits that it pays out when it buys government or mortgage-backed securities.

The Federal Reserve is not a government entity. It is a private institution that functions at the courtesy of the U.S. government. It is essentially the banker to all other U.S. banks. It is beholden to Congress, which can amend the central bank's powers – or even strip them away. But it is permitted to operate with substantial independence.

U.S. government officials and the nation's most powerful banks created the institution under the Federal Reserve Act of 1913. Its creation – and even its early evolution – was fraught with intrigue and self-dealing. Today, however, it's viewed as necessary by most, and a necessary evil by some. But it is necessary.

The Deep Game Dealers Play

Thanks to its independence, the Fed, theoretically, controls monetary policy without the undue influence of politicians. While it might not be beholden to politicians in its role as a monetary policymaker, make no mistake: The central bank is beholden to the banks that make up its system – which are also the banks from whose ranks the Fed's positions of power and authority are filled.

Mechanically here's how the Fed is enriching its family of insiders. By keeping interest rates low for years – not to mention by aiding and abetting an unregulated derivatives market – the central bank helped foster the mortgage fiasco in the nation's prime and subprime mortgage markets.

Leveraged banks blew up and had to be rescued. The Fed did its part by opening its arms and offering unlimited funds to keep favored institutions liquid enough to survive.

Courtesy of the 0.00% Fed-Funds target rate, the central bank gave those banks what were essentially no-interest/low-interest loans to buy risk-free Treasury securities across different maturities. And now, through the miracle of quantitative easing, the Fed is buying those Treasuries back from the banks – thereby handing these institutions handsome capital gains on top of the free interest the banks collected while holding the securities.

The story is actually quite a bit more unseemly than it initially appears: There are currently 18 primary dealers that have the sole authority to buy and sell directly with the Federal Reserve Bank of New York, which conducts the Fed's open-market operations. All other banks and financial institutions – including such giant money managers as PIMCO and BlackRock Inc. (NYSE: BLK), and private individuals who buy or sell at the Fed – only do so as customers of the primary dealers.

The trading desk at the New York Fed is in constant touch with the primary dealers for input on markets and demand for securities. The dealers, of course, are in constant touch with their giant customers – as well as everyone else who matters.

The game goes like this …

Step I: Dealers and big institutional buyers of Treasuries all know the schedule of when the U.S. Treasury auctions new bills, notes and bonds (it's published).

Step II: They drive down the price of issues coming to auction by shorting enough of existing securities whose maturity they know is coming to market (it doesn't take a lot to lower prices, because all the dealers and customers are standing aside and waiting to buy later).

Step III: Since the dealers have lowered the price and raised the yield on existing securities, market buyers put in offers to buy from the Treasury close to the lowered prices for new securities.

Step IV: Once the new issues are bought at lowered prices, dealers and customers bid them up high enough so that when the Fed comes in under its announced schedule of quantitative-easing purchases to buy different maturity securities, the dealers sell back the now-inflated bonds held by them and their customers – netting a tidy profit in the process.

Who is paying these higher prices and providing the windfall to the banks?

The U.S. taxpayers, of course (in other words, you are).

A Look Ahead

The Fed is using credits backed by the taxing power that the U.S. Treasury holds over American taxpayers to hand the banks money to pay big bonuses and to start paying dividends again.

Why do they want to start paying dividends again? That's simple. By resuming dividend payouts, banks:

  • Will see their stock prices rise.
  • Will have more equity.
  • Will be able to leverage themselves more.
  • So they can take bigger risks in order to pay out bigger bonuses – much of which will be paid out in … you guessed it … each bank's stock.

That's the primary goal of QE2 -- enrich the banks. They're doing pretty well after the crisis they precipitated. Meanwhile, the almost $2 trillion spent on the first round of quantitative easing did nothing to reduce unemployment.

So while it's a given that the new round of QE2 will enrich banks, it's doubtful it will stimulate job growth.

There's another angle to this, too: The Nov. 3 announcement that QE2 would have the Fed buying $600 billion of securities through the end of the second quarter of next year wouldn't be completely accurate. The Fed will actually be buying nearly $900 billion worth of securities – if you factor in the reality that the central bank is buying more securities with maturing bonds running off its balance sheet.

While Congress might jawbone about forcing the Fed to abandon the part of its dual mandate to seek to maintain full employment, even as it attempts to keep inflation at bay, our elected leaders are just blowing smoke.

Our congressional representatives – the majority of whom have taken ungodly sums from financial-services industry lobbyists – are giving the banks what they paid for. And Congress likes the fact that if the Fed's QE2 initiative fails to cut U.S. unemployment, the blame can be passed to the central bank.

The sad-and-scary reality is that Congress has no policies to address fixing the economy or creating jobs. Our elected officials spend most of their time trying to get elected and re-elected. Given the latest political division in Congress, it looks like we're headed for more gridlock.

What's unspoken is that this scenario actually suits Congress pretty well. Because of their inability to create and implement desperately needed bipartisan policies to fix what's wrong with our economy and government, our congressional leaders get to punt policy decisions to their backroom masters, the Federal Reserve.

As long as the Fed is running this country, which it is, don't fool yourself: There will be no reduction in unemployment, and no job growth; the only industry that our central bank cares about is the one that it serves – the financial-services sector.

So if you're an investor who's currently "in" the market, here's how to bet: Banks will make a comeback, inflation will be a big part of our future in order to monetize our insane budget deficits, and there will be lots more trouble to come when the bubbles that the Fed is currently inflating finally pop.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When that downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. The next morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, and carefully demonstrates how to profit from every one.

But he doesn't stop there. He's also the consummate risk manager. As the article above demonstrates, Gilani also makes sure to highlight the market pitfalls that can ruin years of careful investing and saving.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. Those essays can be accessed by clicking here.]

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Why the Federal Reserve's Quantitative Easing Strategy Won't Save the U.S. Economy

About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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