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By Jason Stipp | 10-27-2010 01:24 PM

QE2 Charts a Dangerous Course

Although the Fed hopes more quantitative easing will raise asset values and spur the wealth effect, it runs the risk of blowing another bubble, says Morningstar's Bob Johnson.

Jason Stipp: I'm Jason Stipp for Morningstar.

The market has been very keyed in on two little of letters recently, QE, Quantitative Easing.

But what exactly is quantitative easing, and is it as positive as investors think it is?

Joining me today for a little Q&A on QE is Morningstar's Bob Johnson, director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Thank you.

Stipp: First question for you, quantitative easing, it's thrown around a lot, what exactly does it mean?

Johnson: It's a way the Fed uses to reduce a longer-term interest rates, and it's a relatively new phenomenon. Historically, the Federal Reserve has tried to influence only short-term rates. That's really their charter to control inflation through the use of short-term rates--the discount rate, the Fed funds rate, and those are really the key tools at their disposal.

Now with quantitative easing, they're going a little further because already the short-term rates are close to zero, so they can't reduce those any further. So now, they're trying to directly influence longer-term rates and bring those down as well. So what they will do is go out and purchase longer-term Treasury instruments, and by buying those, they'll make the price of those instruments go up and that makes the interest rate go down, and so that's what they're really trying to achieve here, is driving interest rates down more directly.

Stipp: So, obviously, the goal is to make rates lower. What are the positive effects of that? What does the Fed hope will happen because we have lower rates now?

Johnson: There are a lot of things that they're hoping for to happen. I mean, obviously, lower rates mean lower mortgage rates and that stimulates housing and auto opportunities. Things that are interest rate sensitive, it helps drive those. For people who already have mortgages and refinance at these new lower rates, it puts more money in their pockets that they can go out and spend, so that's certainly a positive.

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