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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:

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

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

Read full bio

  1. JOE POWELL | November 19, 2010


  2. Luutzen | November 19, 2010

    This seems absolutely true to me, being only a bachelor economist whoever.

    Measures to be implemented, to create truly competitive financial markets:

    1. No more discount money rates for banks, only FED money to government at 0% (just a change of law, :D)
    2. Congress has to check all interest rates and QE policies.
    3. transparency laws for Congress members and FED: by law all their transaction must be published on websites and audited by SEC.
    2. laws to impede banklobbying, make it a criminal offense
    3. ban the CDS and regulate financial derivatives
    4. Split up the financial markets by law : update Glass-Steagul act
    5. Split up and wind down the to big too fail banks
    6. Put a limit on corporate size by law, tax away revenue.
    7. Big corporations are the cancer to free markets (This is an economic law (Adam Smith))

    • Anastasia | June 29, 2013

      Bernie, why do you pay high ATM fees? I don't – I can't stand them! My bank doesn't charge me to use their ATM, so I plan out my cash wwdatraihls judiciously. As for min. balances, not every bank has them. Why aren't you shopping around? Banks HAVE to make money somehow. When interest rates are low, it's got to come from fees. Bad loans? Stupid banks that made bad loans should have been punished for it. Instead, they got a shovel full of money thrown at them from the government. If you had a child who did something bad – say stole money to buy a toy, and you gave them candy, do you think that child would ever change their ways? No. It's that simple.

  3. Chris Vandegriend | November 19, 2010

    What a great article. It is what I thought all along. i am so skeptical of the banks and their relationtionship with the Feds. When is someone going to blow the whistle, or does anyone really care?

  4. Michael Steinberg | November 19, 2010

    Right on!!! You tell it like it is….the country can go to hell, bankers get richer, and Congress is not only impotent, but feeling good by not taking responsibility….sweet for everyone but the suckered American (ignorant, passive) public!

  5. jj | November 19, 2010

    Actually it's the people of this country who have voted for more govt over the years.Now govt is so large,it is the middle man destroying wealth.The voters are short term greedy and long term stupid and don't know what a proper govt should be. They continue voting for more govt spending and lower taxes.You can't get something for nothing so the Fed ends up creating the inflation tax that pays the difference.We either need a much smaller govt that can't do so much damage to the country or we need some intelligent people(dictator?) running it.I don't see either happening.

  6. marrk noeth | November 19, 2010

    Well, it is safe to admit it all now. 97 years after the FED creation, it's now so ingrained that it's ok to tell the public (not that they're listening) that they actually run the country and have always created money from thin air (through congressional license via Federal Reserve Act 1913). Do you feel patriotic? Toward what? Your country? Define your 'country'. Likely the definition you come up with has faded long ago. Get used to it. It is all done in the name of peace. This is all quite necessary to consolidate & make more efficient the efforts to obtain world peace by leveling the playing field worldwide. I suggest not complaining nor lifting a single finger to interfere with anything. For one thing it's not correctable. You want human sovereignty? You got it. Watch it play out. See what happens. "As you see these things start to occur, raise yourselves erect and lift your heads up…." (a word to the wise is sufficient)

  7. K Petzinger | November 19, 2010

    Thank you so much for beinging much needed clarity to Fed operations. I am tired of supporting "too big to fail" banks. It seems clear that we need a new policy of rewarding savers and investors instead of borrowers and consumers — zero interest rates are an abomination; a bubble waiting to burst. I hope new House Republicans will open hearings into the shenanigans.

  8. Brian E. Schaefer | November 19, 2010

    My understanding of this crisis in the beginning was that the banks need to be made sound or we were heading for a liquidity crisis. That with a sound banking system in place, other problems could then be dealt with. I didn't think that quantitative easing one or two was intended to reduce unemployment but those two issues keep getting linked. If the customers don't come in the store, there's no reason to keep stocking the shelves and hire more employees, is there? I think we now have a crisis of confidence and lower interest rates aren't going to fix that.

  9. Jerry Ballard | November 19, 2010

    "inflation will be a big part of our future in order to monetize our insane budget deficits"
    This phrase was taken from Shah Gilani's article: WHY THE FED RESERVE'S QE WON'T……………
    Could someone explain this?

  10. Sergey | November 19, 2010

    A very useful report. Is shows that the game is not so sophisticated as it could
    seem to the ordinary people. But if the game goes on and other industries but
    financial will start to disappear, how could US administration get through this situation
    without radical political steps mainly abroad?

  11. Gerry | November 19, 2010

    thanks for the insight. I think we all are in deep sh–!

  12. Hivno | November 19, 2010

    Excellent article – thanks !!

  13. Tom | November 19, 2010

    Love your letter, please send

  14. Manfred Nitsch | November 19, 2010

    As an economics professor from the Keynesian side, I don't share your opinion. The FED seems to me right, because a credit crunch is still looming, and the crazy Republicans are blocking all the reasonable ways out of public debt. On the other side of the Pacific, China doesn't devalue its currency. What else can be done by the FED than trying to devalue its currency instead, namely the US$, and ease the debt burden of private and public debtors alike.
    Of course, creditors don't like that. And aren't you very much on their side with your comments ?
    Yours cordially,
    Manfred Nitsch

    • Carla Meisel | December 3, 2010

      I do not understand how you can say "crazy Republicans are blocking all the reasonable ways out of public debt." Could you be specific? Republicans have been in the minority in Congress for some time now and could not even have blocked a weak, 80 pound football player. Even after our recent elections, their power to effectively block (or, perhaps, more importantly, enact possible improvements) will be limited for at least 2 more years. It will take a completely different mindset for Republicans AND Democrats to possibly save our economy and our nation. Very sad to behold and painful for most of us. Playing the blame game is not helpful or productive! We do not have time for that!

  15. fallingman | November 20, 2010

    I'm simply stunned to see the unvarnished truth presented so plainly here. And stunned is an understatement.

    It's as if someone just lifted the veil.

    Hey pal, you're my new hero.

  16. Norm | November 20, 2010

    I must be missing something. Maybe someone can explain my error…

    1. The Fed is (via QE2) increasing their assets by $600B

    2. All the media reports and articles view this as simply $600B being pumped into the US economy over the next several months

    3. This $600B figure is gigantic, but is still comparable in size to the prior "stimulus" injections, and therefore viewed as just one more similar step in the "recovery" process

    4. But I think this step may actually NOT be comparable in size at all

    5. The prior stimulus plans shelled out money to "normal" spending entities, e.g. corporations, municipalities, non-profits

    6. But this $600B is not going directly to "normal" spending entities

    7. It is going to "special" entities (the banking system, as explained in the above article) and becomes excess reserves that magically get transformed by our wonderful fractional-reserve (only about 10%) money-multiplier (about 10x) system

    8. So, isn't this actually more like a $600B x 10 = $6 Trillion injection?

  17. Darren Harder | November 20, 2010

    the fed is no longer independent. it hasn't been since the Clinton administration.

  18. James | November 30, 2010

    This article cuts through the chaff and goes to the heart of the matter. It educates the reader on how the Federal Reserve works and who it serves, i.e. the big banks. It becomes thought provoking when the reader is equipped with this new knowledge and he is able to make a little more sense of what the Federal Reserve is doing to manage our economy.

    The US economy is already making slow recovery at an annual rate of 2.8 percent and heading for further improvements going into 2011 and 2012. Unemployment although remaining high should be declining as businesses revive and more people get hired.

    The question in my mind is should the US go in deeper debt to boost an economy that is already on the mend? What the Federal Reserve is doing is dangerous. All it does is put our country more at risk for inflation and making our country become more fragile because of the higher debt. All it has to do now is make small moves, not big ones like Quantitative Easing II. Does Keynesian economics have an answer to going into deeper debt when a country is already in deep, deep debt? People are terrified! It is not only the Republicans that are scared. The Democrats are scared too and helped vote the Republicans into office recently. The benefits of Quantitative Easing II in decreasing unemployment as described in your article is minimal because it does not directly create jobs. All it does is enrich and benefit the financial sector at the expense of the rest of our country.

    The Federal Reserves wields tremendous power. What it does affects people in different ways. Some benefit while others don't. The banks do while the little guys don't. Wasn't it the late President John F. Kennedy who said, "Who said life is fair?"

  19. Leland Waterman | December 10, 2010

    Very good article on what the FED actually DOES!! The news for Mr. B is that China has cut back on Treasury Notes because of the paltry 3% interest rates and now they are set to acquire all the natural resource reserves in the USA and around the world involved in oil, gas, coal and other mineral resources. The stocks of metallurgical coal miners has already started to raise because of increased demand from China and India. Walters Energy just acquired a 3-billion coal reserve in British Columbia and the stock has went up about 25 USD in the last two months, thanks to the FED helping the mega banks survive!!

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