Quantitative Easing Definition

Quantitative easing (QE) is a government monetary policy in which the total money supply is increased through the Federal Reserve purchasing its own Treasury bonds from banks on the open market. Instead of printing the cash to make this purchase, the government simply creates it out of thin air, electronically.

The purpose in creating this additional money is to give money to banks so that they lend more, which theoretically in turn, stimulates the economy. In reality, it is much more complicated than this layman’s description, but that is the gist of it.

What is QE2 & QE1?

QE1 occurred back during the beginning of the financial crisis, when the Federal Reserve (the U.S. central bank) cut short-term interest rates, essentially down to 0%, to stimulate lending by banks to businesses and consumers. Since this measure has been exhausted, it is now shifting its focus to long-term interest rates. When the Fed buys all of these bonds, it will have the impact of driving the yields on them lower, which should theoretically make other investments more attractive.

The Fed is also attempting to avoid deflation, and creating additional money should have inflationary impact.

The Risks of Quantitative Easing & How it Impacts You

Devaluing of U.S. Dollar vs. Other Currencies: This is not so much a risk as it is a given. When you create more dollars out of thin air, you are devaluing the existing money supply versus other currencies. As one consequence, travel will be more expensive as your U.S. dollars will buy you less elsewhere.

Inflation: Currency devaluation also means that your dollar will buy you less as the goods that are imported into the U.S. will cost more. Prices are driven upwards because your dollar is worth less compared to other currencies. At this point, we don’t really know what kind of an inflationary impact quantitative easing might have.

Investing Dangers: What makes inflation, or hyper-inflation scary from an investment perspective is the danger of holding on to money that is worth significantly less over time. Many investors have simply given up on the stock market and turned to more predictable positive (and usually abysmal) returns. With inflation potentially going upwards, this conservative investment strategy could be an extremely dangerous one. In effect, if we see inflation rates start to significantly increase, my bet is that you’re going to see much of those who have been sitting on the sidelines with their cash all of a sudden jump back in to the stock market. This could drive stock prices significantly upwards, and those sitting behind with their cash will have lost much of the value of their cash to inflation.

Going Back to what Got us Into this Mess: Maybe my analysis is off base here, but I find it ironic that the Fed wants to stimulate the economy through banks lending more money. Isn’t banks lending too much money to people who couldn’t pay them back exactly what caused the financial crisis that sent us into the Great Recession in the first place?

Quantitative Easing Discussion

I’m not convinced that quantitative easing will have a positive impact and the risk involved seems to be significant. Is the result worth the risk? The Fed seems to think so.

• What do you think?
• If you can give a better explanation of quantitative easing, please do, I’m no economist.
• Does fear of inflation impact your investment strategy?

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• How to Beat Inflation
• Index Funds vs. Mutual Funds
• How to Make a Stock Trade

Quantitative Easing Definition & How it Impacts you is copyrighted by 20somethingfinance.com without consent to republish.

This is a guest post from Shaun Connell, author of Learn Financial Planning, a series of free, comprehensive financial planning tutorials.

It’s hard to watch the news or keep up with anything financial without hearing about inflation, deflation and our current money supply. Understanding inflation is essential to the basics of personal finance. It’s not just an economic concept it impacts you every day, and is only of the biggest obstacles your investments will face.

Inflation is when your dollar loses it’s buying power. Inflation is when is takes more currency to buy the same amount of stuff.

Take penny candy, for example. I still remember when I could buy a small piece of candy for a penny. Now, I haven’t seen penny candy in years. This doesn’t mean the candy disappeared. No, you can still buy the candy I used to buy… now it just costs ten cents or more. This means one of two things:

1. Candy is becoming more valuable, OR
2. Our currency is becoming less valuable

The second is, by far, the most important concept to understand. That’s because the price of almost everything has gone up over the past few decades. Overall, our money is becoming worth less and less. The penny isn’t what it used to be.

But why? What does this mean for us?

What Causes Inflation?

One of the most basic principles of economics is how the law of supply and demand affects prices. If there’s a bunch of something, it’s usually not valuable. If there’s not much of something, it’s usually pretty valuable. To simplify the concept: the more that’s available, the less it’s worth.

For example, a truckload of gold is worth more than a truckload of sand. It’s all about what economists call “scarcity.”

Remember, our money isn’t inherently worth anything. It only has worth because people think it does, and because it’s relatively scarce. There aren’t millions of dollars under every bed. Money simply represents the real material wealth that others own. If there’s more paper and less wealth, then the ratio of dollars to value goes down, the dollars are worthless.

So what causes inflation? Though there are an incredible number of complicated smaller causes, the biggest cause is simple: the government decides to print more money. The actual material wealth in the economy isn’t changing. The government doesn’t make money; the government just prints money.

Inflation is what happens when there’s more “money” being created than there is worth being added. In other words, if the government prints 100 trillion new dollars, and our real GDP only grows about 10 trillion dollars, we’ll be seeing roughly 90 trillion dollars diluting the value of other dollars. That’s inflation.

But why should we care about inflation?

How Inflation Hurts You

Inflation slowly erodes the value of your wealth. The average yearly inflation is about 3.43%. This means that every single year, the cash you have is worth 3.43% less. That might not sound like much, but it’s simply mindboggling:

• Fact: Investments really make less than you think. If you make an average of 6% return in your investments every year, you’re actually only making about 2.6% per year after factoring into account inflation.

• Fact: Investment fees are eating into your returns. If you are paying anything more than $5 for your trades, you’re getting hammered. Zecco has free trades and investment accounts with zero fees. They have great service as well.

• Fact: For most people, a “raise” breaks even, maybe. If you get a 10% raise every three years, you aren’t actually getting a raise at all. You’re actually living on 3% and 6% less for two years preceding your raise after factoring into account inflation.

Inflation especially affects the people in the lower income rungs. Right now you can’t get away from hearing about inflation and deflation — it’s all over the news. Why? And what should you do?

What is Deflation?

Right now, we’re actually seeing a major amount of deflation, caused by the recession and low oil prices. This means that your money actually has a bit more buying power than usual.

But don’t get comfortable. We’re about to see record levels of inflation in the next few months and/or years. Just consider the following facts:

• Fact: More Fed loans are given, increasing inflation. All over the news, you can see reports that the Federal Reserve is lowering interest rates down to nearly 0%. This means the Federal Reserve (the people who print money) will be giving out more “loans.” A “loan” is when we give money that doesn’t yet exist for banks to loan out. The lower the interest rate, the more loans are given out, the more money is printed.

• Fact: We’re already printing a lot, increasing inflation. In the past few months, the Federal Reserve has already printed more money than the last 19 years combined.

• Fact: Spending increases printing, increasing inflation. Over the past few months, Bush has spent over a trillion dollars to help the economy. Obama has already pledged at least another trillion towards his economic stimulus alone. Spending several trillion dollars is a surefire way of increasing inflation.

I’m not saying the world is going to end — just that inflation is going to start again, and soon. We’re seeing deflation right now, which means one thing: This is the perfect time to get prepared.

How to Beat the Future Inflation

Understanding inflation isn’t enough; you have to be willing to take actions to “beat” inflation. Though there are many tactics, the four tips below are simply a must for a rational financial plan:

• Stock Up. Remember, as we’ve talked about before, we’re currently in the middle of deflation. That means that items that will be increasing in costs in just a few months to a year are actually much, much cheaper. So stock up. Buy bigger boxes and value packs. This is usually still a good idea, but right now it makes even more sense.

• Precious Metals. Usually, I’m not a big fan of precious metals like gold and silver, and encourage their purchase only for the sake of diversity and financial security. But due to the recession, the price of gold looks good. Precious metals are also a great “crisis hedge” in the sense that during times of crisis, investors often flee back to precious metals.

• Save, Save, Save. As mentioned before, a high-interest savings account will allow you to just break even. But right now, with deflation, you’ll actually be making even more. Remember, deflation is the opposite of inflation, which means for every 1% of deflation, your money’s value increases about 1%. This means that you should be storing your money away while in deflation periods for two reasons:

1. To have extra money on hand when prices increase, and
2. To make an extra couple of percentage points due to the deflation.

• Get That Raise. Though this might be considered a “duh” point, it’s important to understand. Inflation means you’re getting a built in pay cut of at least 3% every year. In the next few years, that’s going to get worse… a lot worse. This means that now, more than ever before, is the time to focus on working harder and doing things that will get you noticed. At this point, getting a raise is often still just a defensive measure.

Inflation Conclusion

Remember, the laws of economics don’t change just because we’re having a financially rough time. If anything, this is the time we should focus on the economic and financial principles that get us to prosperity.

This means you don’t have to do anything “special” to combat inflation: just do what you already know you should do. Extraordinary financial times call for extra ordinary financial measures.

Inflation Discussion:

How is inflation impacting your long-term savings plans?

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Inflation: How to Beat it with Smart Financial Planning is copyrighted by 20somethingfinance.com without consent to republish.

Lately, the Fed has started to talk about real inflation, including food and energy, because it’s simply been too alarming to ignore any longer. Let’s take a look at how we got into this mess and whether or not it’s here to stay.

Energy Inflation

When you break it down we all know that fuel prices have skyrocketed. The exact reasons are somewhat unclear, but it appears to be a mixed drink of a number of factors including rising demand from emerging economies like India and China, OPEC collaboration to limit production, speculators on Wall Street, and even the possibility that we’ve reached ‘Peak Oil’ – the anticipated point where the world’s oil supply hits peak production capacity, while demand continues to increase.

Food Inflation

Additionally, grain prices have skyrocketed, driving up the costs of just about all food prices. Why has this happened? Good ole’ ethanol and growing worldwide demand, for starters. With ethanol being the ‘in thing’ as a knee jerk reaction to offset carbon emissions (and ethanol producers profiting massively), corn, the prime component of ethanol has been in high demand. With corn prices high, farmers profit when they grow it. As a result, they’ve given an incredible about of acreage to the crop and limited acreage to all other crops. This has resulted in the prices of all other crops increasing across the board.

Not only have other crops increased in price, but all foods with the exception of fruits and vegetables are primarily based upon production of these grains. Cows, hogs, and chicken all need food to eat. As a result, milk, eggs, and meat have all risen in price. Let’s also not forget that our food has to get from the place of production to our local supermarket, and someone has to pay for the price in fuel increases. Whom may that be? Here’s a hint: consumers don’t have the option of passing along prices increases. One domino after the other.

Everything Inflation

This year alone has seen some huge run-ups in prices across the board on everyday commodities that we consume. We’re at the half-way point for the year, let’s take a look at the score board:

Energy

• Crude oil +42.5%
• Ethanol +20.7%
• Unleaded gas +39.5%
• Heating oil +43.9%
• Natural gas +76.5%

Food

• Cattle +1.0% (surprisingly low, maybe hormones have been increased to offset the grain increases?)
• Corn +58.8%
• Soy bean +26.4%
• Wheat -2.2%
• Coffee +5.9%

What about some of the commodities, which are often purchased as a hedge against inflation?

• Aluminum +32.7% (think canned goods)
• Copper +25.7
• Silver +13.4%.
• Platinum +33.4%
• Gold + 6.0%

When inflation goes up, the markets usually go down.

• S&P 500 -10.24%
• Frankfurt DAX -18.32%
• Seoul Composite -9.57%
• London FTSE -12.23%
• Paris CAC -19.64%
• Hong Kong Hang Sang -18.33%.
• Tokyo Nikkei -9.47%
• Singapore Straits -14.04%.
• Sydney All Ordinary -15.76%
• Taipei Telex -7.40%
• Shanghai Shanghai B -44.42%

We truly do live in a global market, eh?

The Broad Effects of Inflation

The media has jumped on this idea that ‘everything else is still cheap’ and as I mentioned earlier, the Fed has talked up the fact that ‘core inflation’ is still very low. Everything else being the non-food or energy related goods. Although this may be true at this exact moment in time, there are troubling signs that this is all about to change. Recently, Dow Chemical (and a resulting slew of other chemical companies) raised prices 25% across the board, just one month after raising them 20%!

Why is this big news? Dow and it’s competitors are engaged in the manufacture and sale of chemicals, plastic materials, agricultural and other specialized products and services. Dow services customers in 160 countries, helping them to provide fresh water, food, pharmaceuticals, paints, packaging and personal care. They produce approximately 3,100 products.

“The higher bill at the end of the day winds up in the lap of the consumer,” Ben Johnson, a Chicago-based analyst at Morningstar Inc., said in a Bloomberg Radio interview. “It’s going to eventually filter through to those core inflation numbers.”

What can you Do to Fight Inflation?

You do have some options. Stay tuned for upcoming posts!

Inflation Discussion

In the meantime, I’d love to hear what you think about all of this.

• Are you worried about inflation?
• Do you think it’s here to stay?
• What kind of problems is it causing for you?
• What kind of global problems do you see inflation creating?

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• How to Beat Inflation
• How to Get Over the Fear of Investing
• Nitrogen Tire Inflation
• How to Make a Stock Trade

Inflation is Back with a Vengeance. Will it Stay? is copyrighted by 20somethingfinance.com without consent to republish.