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QE2: $600 Billion Fed Move Targets New Jobs, But Risks Inflation

The Federal Open Market Committee reported today that the central bank would undertake another round of quantitative easing, to keep a lid on long-term interest rates and make business investment more affordable and meet the Fed's goal of creating jobs. The board announced a $600 billion program, above the market's expectation of $500 billion. The move is like a "Hail Mary" pass, a bold and risky step. The financial markets should like the news, because low interest rates support the prices of bonds and stocks, but economists worry about the inflation that might follow.

One goal of QE2 is to push down long-term interest rates, to make mortgages more affordable for consumers, and reduce the cost of new projects for businesses. The last round of QE is estimated to have been pretty effective, reducing long-term rates by between 0.5 percent and 1.0 percent. One economist estimates the yield on the 10-year Treasury bond will fall to 2.25 percent, from 2.5 percent before the move.

A second goal is to reduce the value of the dollar in world markets, making exports by U.S. companies cheaper to foreign buyers. Lower interest rates make U.S. securities less attractive, so investors need to buy fewer dollars, thus the price drop.

Combined, these two effects of lower rates should meet the Fed's primary goal of creating jobs in the U.S. Chairman Ben Bernanke had sent out plenty of signals ahead of time so the size of the QE -- $600 billion -- should not be a surprise to the markets.

There's a potential downside, in potentially higher inflation. The lower dollar means Americans have to pay more for imported goods. And for raw materials that are priced in dollars on the world markets, such as oil, grains and cotton, the dollar price has to rise to stay equal with what those goods are worth in other currencies. (Eventually, however, a few years down the road, persistent inflation would lead to higher interest rates.)

Will keeping interest rates low encourage business to hire people again? So far, big companies have been able to expand their exports without creating many new positions. The average S&P 500 company sells about half its products overseas, so if export volumes keep rising, sooner or later they'll have to add people.

Here at home, though, it's hard to see how lower rates will achieve much more than they already have. The last QE effort, in the depths of the financial crisis, was three or four times largest than the planned QE2. With a large inventory of houses on the market, a poor employment market and cautious consumers, we're still a long way from using full capacity in the economy. But lower rates, at least for the time being, should cheer up bond and stock investors.