Will pumping more money into the US economy work?

Can the US finally wake up its economy by injecting another $1 trillion? Or is this more an act of desperation than calculation?.

The US Federal Reserve (which has a similar role to our Bank of England) has announced it will pump $600 billion into the ailing US economy over the next 8 months along with the $250-300 billion it expects to receive from repayments on debt and mortgage-backed securities it owns.

This move, called quantitative easing ('QE2' in this instance), is intended to get the US economy moving again. But it's a bit like pouring petrol onto a smouldering bonfire; while it'll stir up some flames quite quickly, there's a risk they'll die out rather than get the bonfire roaring again.

How bad are things in the US?

Unemployment is sticking at around 9.6% and economic growth remains slow, at an annual rate of 2% for the third quarter. The economy isn't collapsing, but it's not really going anywhere either and this is a big worry for the Fed.

The US housing market is also in crisis, estimates suggest 930,000 homes are currently being foreclosed (i.e. in the process of being repossessed).

How does the Fed pump money into the economy?

It prints money then uses this to buy government bonds, mostly from banks. It then hopes that the banks either invest this money, or lend it to customers who spend it, so that it finds its way into the economy.

Hasn't it already pumped lots of money into the US economy?

Yes. The Fed announced a $600 billion injection in November 2008 that increased to £1.8 trillion 4 months later when it became clear it wasn't enough.

Is the Fed throwing good money after bad?

Maybe. But while the initial quantitative easing hasn't got the US economy firing on all cylinders again, the present situation could be worse still had the injection not happened.

Trouble is, the US economy is in a rut and printing more money is really the Fed's only viable option to try and get things moving again. Cutting interest rates (which encourages spending by making borrowing cheaper) is not an option given US rates have been stuck at just 0.25% since December 2008.

What are the risks?

If banks and consumers decide to save most of the extra money rather than lend/spend it, then it will do little to stimulate the economy and the Fed's plan would fail.

And if the extra dollars are spent then prices could rise (e.g. if my economy has £100 and produces 100 widgets they'd be priced £1 each. If I double the money supply to £200 but still only produce 100 widget their price would likely rise to £2, equal to 100% inflation).

This would be bad as rising inflation is the last thing the Fed needs right now. Because high inflation is generally undesirable (it stifles investment) the Fed would normally raise interest rates to keep it at bay (i.e. discourage spending by increasing the cost of borrowing), but raising interest rates at the moment could be the straw that breaks the camel's back as it will discourage spending at a time when the economy needs it more than ever.

Printing extra money could also weaken US currency as there's more of it in circulation (in the same way the price of food usually falls when there's more available). A weaker dollar helps US exports as they'll be cheaper (although other countries may retaliate and devalue their currencies so the US doesn't gain a competitive advantage), but may be seen as a sign of weakness and reduce foreign investment in the US.

How will US quantitative easing affect stockmarkets and other investments?

In the very short term stockmarkets will jump for joy in the expectation that some of the money will ultimately be used to buy shares. And they'll also be hoping the money will increase spending and boost company profits. The price of US government bonds (Treasuries) will also probably rise in anticipation of the Fed's spending spree.

But whether the initial excitement lasts is another matter. This will really depend on whether the Fed's plan works.

A weaker dollar is bad news for UK investors with US investments, as it reduces the value when converted back into pounds. But a weak dollar could be good news for gold and other assets priced in dollars, as it reduces the price tag for foreign investors - although this would pile more upward pressure on inflation.

So, will it work?

I do hope so, but I have my doubts. While pumping $950-1,000 billion into the US economy will undoubtedly make some difference, I'm not sure the difference will be big enough. Evidence suggests both banks and customers are becoming increasingly cautious, so the majority of the money may not end up being spent - doing little to boost the economy. And if lots of the money is spent then inflation could rise, discouraging further spending/investment and potentially slowing the economy once more...

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