by Ben Baden

Experts says it hurts savers and adds to the deficit

It's been almost two years since the Federal Reserve set interest rates to the current near-zero levels. The Fed has kept the target range for the federal funds rate (the interest rate at which banks lend to each other) between zero and 0.25 percent since December 2008 and has, since March 2009, repeated its pledge to keep rates low for an "extended period." That's a signal that it doesn't plan on changing its tune any time soon, experts say.

On top of record-low interest rates, the Fed has also pursued a strategy called quantitative easing, which involves buying up government securities like treasuries to push interest rates even lower in hopes of stimulating more lending to spur economic activity. The first round of quantitative easing started in 2008, and many experts believe the Fed will announce plans to begin another asset-buying program (referred to as QE2) in its next rate announcement in November. Here are four reasons why another round of asset purchases could be problematic:

Savers are hurting.

The yield on the 10-year treasury note has hovered around 2.5 percent for most of the latter half of 2010. Historically, rates have been much higher. In mid-2007, when economic growth was much more robust and demand for treasuries was much lower, 10-year treasuries were yielding as much as 5 percent. Many older investors depend on the income they receive from their investments in high-quality bonds like treasuries, and faced with paltry treasury yields, many are considering whether they should take on more risk. "It forces people out the risk spectrum in order to get yield, and a lot of people that are forced out the risk spectrum shouldn't be forced out the risk spectrum," says Liz Ann Sonders, chief investment strategist at Charles Schwab. Rates can only move higher, and when they do, investors that have moved farther down the duration scale (a measure of interest-rate sensitivity) will feel the pain. When interest rates rise, the price of bonds falls--and longer duration bonds will be hit harder than others.

It would add to the deficit.

By buying up more assets, the Fed is essentially printing more money and adding to the already ballooning deficit. If the Fed were to buy up more securities, it must print the money to do so. It is expected to buy more treasuries if it pursues another easing strategy. In this case, Sonders says the biggest holders of these treasuries are banks, so the Fed is effectively putting the cash into the banks and taking the treasuries off the banks' books. The hope is that this will stimulate big banks to lend more instead of sit on piles of cash. In a recent note, Richard B. Hoey, chief economist at BNY Mellon writes, "We believe that QE2 would be a powerful medicine with potentially severe side effects. While the Federal Reserve could force down treasury bond yields temporarily by creating a temporary scarcity of long-duration treasury securities, it would do so at the cost of higher treasury bond yields in future years, when rising treasury debt will need to be permanently financed." In other words, buying more treasuries now could lead to bigger issues down the road when the government is forced to take on the issue of its massive deficit.

Activity is frozen.

When the Fed says it doesn't plan on raising rates for an "extended period," it's essentially saying that there's a good chance the situation won't change much in the short term. "It basically halts activity because if you anticipate rates are going down in the future, there's no incentive to do anything now," Sonders says. "There's no fire that's lit under borrowers or lenders." If the Fed were to change its tone somewhat, investors, businesses, and banks may reconsider the way they view the situation. Sonders believes that if the Fed were to change its views, it would inspire institutions to act instead of sitting back while interest rates remain near zero for an indefinite amount of time.

Confidence is low.

Experts agree that one of the biggest problems facing the economy is a lack of confidence. Sonders believes the economy has made a lot of progress since the worst of the financial crisis, but Fed policy hasn't changed significantly. "I'm not suggesting we're out of the woods yet and we're clear sailing, but we're arguably out of the Armageddon phase of the crisis," Sonders says. Fears that the economy could dip into another recession have mostly faded away in the United States, but it's difficult to tell whether the economy has taken a turn for the better until the Fed changes its language, Sonders says. Thomas Hoenig, president of the Kansas City Federal Reserve, has voiced his opposition to current Fed policy. He has been the lone dissenter at every Fed meeting this year. On Tuesday, he told the National Association of Business Economics, "At this point, with a modest recovery under way and inflation low and stable, I believe the economy would be better served by beginning to normalize monetary policy."

Why More Quantitative Easing Could Be a Mistake