Federal Reserve Meeting: The Most Important Vote This Week

Nov. 1, 2010— -- While Americans are heading to their polling places Tuesday to decide who will represent them in the halls of the Capitol, just two miles away the Federal Reserve's Open Market Committee will convene a two-day meeting in its historic Board Room.

It is, arguably, in that room where the most important votes of the week will be cast -- more impactful on the future of the Republic than the millions of individual ballots being cast around the country.

How can this be?

The economy is not getting better. It's growing, but not at a pace where the mass of long-term unemployed and underemployed (more than 26 million Americans) will see strong hiring in the near future. With a Democrat in the White House and the Republicans likely to control one (if not two) houses of Congress, gridlock is a certainty.

John Boehner as a likely future speaker of the House has promised not to "compromise on our principles" in a showdown with the White House. Mitch McConnell might be Majority Leader in a chamber where more than 60 seats are needed to move legislation forward and his announced ambition is to keep President Obama in the White House for only one term.

It means another round of fiscal stimulus is unlikely, if not politically impossible.

So Bernanke and Company at the apolitical Federal Reserve might be one of the only parts of the Federal Government not bogged down in a political standstill after Tuesday's election.

To try to spark spending and hiring, they are planning an ambitious effort to spur the moribund economic recovery with an unprecedented effort called QE2: "Quantitative Easing -- 2nd Round"

What Is Quantitative Easing?

Normally central banks increase or decrease economic activity through adjustments to interest rates. Lower rates make it less expensive to borrow and thus spur spending. Higher rates incentivize saving and make it more expensive to borrow, so economic activity dips. The Fed has deployed all its interest rate firepower -- their key interest rate has been effectively at zero for almost two years.

Since the interest rate gun is out of ammo, the Fed is looking to another weapon -- Quantitative Easing (or QE) as the next step for monetary stimulus.

QE is an unorthodox way to pump money into a faltering economy, hoping to push interest rates the Fed does not control even lower and diminish the incentives people have to save.

All of this is focused on getting enough money bouncing around the economy to spur hiring as companies scramble to grab their piece of the growing economic activity.

QE techniques include buying up government bonds, mortgaged-backed securities, even commercial bonds issued by private companies and consumer lenders. It has the same effect of printing money without having to actually heat-up the presses.

The first round of quantitative easing happened in the early days of the financial crisis, with the Federal Reserve buying up hundreds of billions of dollars in debt. This QE1 took the Fed's balance sheet from the historically normal level of about $900 billion to more than $2 trillion.

The Fed's program was mirrored by central banks across the globe. This coordinated move has been widely credited by economists on both ends of the political spectrum with keeping the global economy from collapsing into a depression.

But QE has risks.

It can be ineffective. Most economists believe QE is most effective in the initial shock value. There is likely a point of diminishing returns where the X-trillionth dollar poured into the system doesn't stimulate as much as the first dollar put in.

On the other hand, if it's too effective, it can spur hyper-inflation where prices jump quickly as the value of the dollar drops.

What will the Fed likely do? The members of the Fed's Open Market Committee have been signaling their desire to introduce a new round of QE during the past month and half.

The market believes Bernanke & Co. will announce a program to buy up Treasury bonds a few $100 billion at a time over the next year. Many people believe they'll say they will purchase between $1 trillion and $2 trillion worth of Treasuries.

The buying program would likely be dependent on the Fed's read of current economic conditions. If employment begins to ramp up, the Fed would likely not commit the full amount. If things deteriorate, the Fed could speed up the purchases.

But keep in mind, all the talk about QE has set expectations. And when Wall Street's expectations are not met, there are real repercussions.

"Everyone has run ahead of the FOMC, but now find themselves less and less sure because of the lack of specifics," said Bob Eisenbeis, chief economist at Cumberland Advisors. "All of this means that the Fed can't simply sit pat and let the market do its work for it. The FOMC not only has to deliver but must do so with sufficient specifics that markets gain more certainty about the future course of policy."

We'll get the specifics on Wednesday afternoon at around 2:15 p.m. ET when the post-meeting statement is released. We won't know QE2's effectiveness for months -- just keep watching that jobs report.