The Federal Reserve is making a high-stakes bet in the hope of getting the economy steaming along again. Nobody is sure the Fed’s efforts will work, though, and they could actually backfire.

The Fed on Wednesday announced a plan to buy $600 billion in government debt, aimed at driving already low long-term interest rates even lower. The central bank would buy the debt in chunks of $75 billion a month through June of next year.

Economists call it quantitative easing. The newest package gets the name QE2 — like the ship — because it’s the second round. The Fed spent about $1.7 trillion from 2008 until earlier this year to take Treasury bonds off the hands of banks and stabilize them.

Here’s how it’s supposed to work: The Fed buys Treasury bonds from banks, providing them cash to lend to customers. Buying so many bonds also lowers interest rates because the Fed’s increased demand for Treasurys leads to higher prices and lower yields. Interest rates on consumer loans are tied to Treasury yields. Lower rates entice people to take out a mortgage or another loan.

At the same time, lower interest rates make relatively safe investments such as bonds and cash less appealing, so companies and investors take the cash and buy equipment or other investments, such as stocks. The stock market takes off, and Americans celebrate with a shopping spree. Businesses see a rise in sales and begin hiring again, and a virtuous cycle of more spending and more hiring ensues.

But many analysts and even supporters of the plan see dangers. It could make the weak dollar even weaker and lead to trade disputes with other countries. It could lead bond traders to think that inflation will run wild, and they could derail the Fed’s efforts by pushing rates higher. Many investors say it could create bubbles as hedge funds and other speculators borrow cheaply and make even bigger bets on stocks, commodities and markets in developing countries such as Brazil.

Here is a closer look at two ways the Fed’s strategy could go wrong:

Dollar drop: As word trickled out over recent months that the Fed was planning a new round of bond purchases, the dollar sank. It hit a 15-year low against the Japanese yen Monday.

Why? In the simplest terms, a country that cuts interest rates makes its currency less attractive to the world’s investors. The interest rate is also the investors’ yield, the payout they receive. When that yield falls, banks move their money into countries with higher rates.

The Fed aims to push up the prices of stocks, bonds, real estate — you name it, said Bill O’Donnell, head of U.S. government bond strategy at the Royal Bank of Scotland. Everything is going to go up but the dollar.

The downside is that a weakened dollar pinches people in the U.S. because anything produced in other countries becomes more expensive, like oranges from Spain or toys from China.

Look around you, said Thomas Atteberry, a fund manager at First Pacific Advisors. How many things can you find that were made in the USA?

Blowing bubbles: Buying bundles of Treasurys knocks down interest rates, making borrowing cheap. But it also motivates investors to move out of safe investments into riskier ones in search of better returns. The stock market, for instance, rises in value, and everyone with savings in stocks feels wealthier. Ideally, it produces what economists call a "wealth effect": People who feel better off spend more.

The problem, according to some critics, is that cheap borrowing costs and buoyant markets make a fertile environment for bubbles, which eventually pop.

Stocks in developing countries are a likely candidate for the next bubble. Cash from Europe and the U.S. has been plowed into emerging markets, such as Brazil and Chile, since the financial crisis, largely because these countries have less debt and faster economic growth than in the developed world.

Another concern: Falling interest rates allow speculators to borrow larger amounts. In the extreme, losses from hedge funds and other borrowers can put their banks at risk and leave governments to clean up the mess.

Source: Statesman.com