By the Fed’s own definition, QE2 is not working.  US 10-year bond yields have risen from 2.5% in October 2010 (when Bernanke first hinted the Fed was going ahead with QE2) to 3.5% currently, with 5 months to go until the Fed finishes spending QE2′s $600 bln.  Bernanke has explained often enough that the Fed sees the transmission mechanism from QE2 Treasury bond buying to the economy being stimulated as via low borrowing rates for companies & households.  Well, rates are backing up and unemployment is stuck around 9.5% and therefore QE2 is not working as planned.  We may get some weasel words from officials suggesting rates would be even higher if the Fed weren’t buying bonds but such words are of little use to a US homebuyer (US 30-year mortgage rates have risen from an historic low of 4.23% in October 2010 to 4.74% currently).

The minutes of the FOMC meetings show that the only dissent in 2010 came from Thomas Hoenig (who doesn’t have an FOMC vote in 2011) who opposed QE2 but didn’t suggest an alternative policy to stimulate an economy with 9.5% unemployment and subdued inflation.  His view can be summed up as “When in a hole, stop digging” (which does have some merits in the case of QE2) but he doesn’t seem to have a Plan B either.

The FOMC has boxed itself into a logical corner here.  Their solution to the current situation of unemployment being too high with inflation currently subdued is to buy bonds to force the yield curve lower so as to stimulate companies & households by enabling them to borrow cheaply for long periods.  Bernanke claims it is not printing money (see his recent CBS 60 Minutes interview) but Bernanke also explained long-ago in his 2002 Deflation speech that we have “a technology, called a printing press (or, today, its electronic equivalent)”.  From where else are they getting the 600 billion dollars with which they are buying all those Treasuries?  It is true that the money commercial banks hold on deposit at the Fed has risen by almost as much as has been spent so far on the two QE programs (and the reason inflation has not yet taken off is that this newly created/printed money has not YET entered the real economy to be spent on goods and services).  However should demand for loans increase then there is nothing to stop this money from quickly entering the real economy.

So what happens at the 9th August FOMC meeting (the first one after QE2 finishes)?  The FOMC must be praying that the unemployment rate has started to trend lower by then because if it is still up around 9.5% (or higher!) then they face a real problem.  They can either follow their own logic and announce an even bigger QE3 program to force the yield curve back down again or they can admit defeat and confess that their QE experiment has not lowered unemployment and come up with an alternative Plan B to stimulate a US economy which is still not creating jobs.  To say that the markets would not react favourably to the Fed admitting defeat is an understatement.

The Fed are in a tight corner because there is no real alternative.  If they announce a QE3 program of gargantuan size to force the yield curve lower then they risk a collapse in the US Dollar.  If they stop buying Treasuries then they risk bond yields spiking higher which would depress the economy (precisely the opposite of what they wish to achieve).  The only other option is to explicitly promise to keep the Fed Funds rate at zero until unemployment falls (however long that takes – possibly years), as long as inflation stays low whilst there is so much spare capacity in the US economy.  As the old saying goes, Time Heals All Wounds, but it will be a rocky ride.