I was the featured speaker at my local real estate club a few days ago. There was a good turnout with the typical mix of novice, moderately experienced, and well-seasoned investors. Before beginning my presentation on evaluating rehab properties, I provided a brief update on a fairly significant economic event that would happen at the end of June. Much to my surprise, not a single person in the room knew about it.
It’s understandable that neophyte investors weren’t aware of it, but even those with decades of experience had no clue as to what I was talking about. When I asked the audience if anyone knew what QE2 was a few people responded that it was a ship. When I mentioned that it was a Federal Reserve strategy designed to stimulate the economy I was met with blank stares. QE2 is the acronym for Quantitative Easing round 2 and it ends on June 30th. Experts disagree on the magnitude, but its end will impact just about every investment vehicle in some way, including real estate.
The Fed’s Tool Kit
The mission of the Federal Reserve, according to its website:
The Federal Reserve sets the nation’s monetary policy to promote the objectives of maximum employment, stable prices, and moderate long-term interest rates.
This role of managing the economy through the money supply is achieved by the use of three primary tools. The most well-known is setting interest rates for Federal Funds. With that rate currently near zero that option is off the table. Another weapon is setting reserve requirements for banks. That is the amount of money banks are required to hold in reserve for each dollar on deposit. Current reserve requirements don’t allow much manipulation at the moment. That leaves one arrow remaining in the quiver – open market operations. This is the buying and selling of US Treasury bonds, bills, and notes on the open market to increase or decrease the amount of money in circulation.
Even if you live in a cave on a remote island in the South Pacific you know that the US Government has been running massive, trillion dollar deficits. Those deficits are funded through the sale of government bonds, bills, and notes. What you may not know is who is buying those debt securities. Why, it’s none other than the Federal Reserve. That’s QE2. In a nutshell, the government has been printing money and backing it with nothing more than a bookkeeping entry on the nation’s balance sheet. The policy can’t continue indefinitely and that’s why it’s ending. But who is going to buy the bonds we are now buying from ourselves?
Raise Your Awareness
The recent real estate bubble was, in hindsight, unsustainable. When it burst a great many people were caught with their pants down and hurt financially. The warning signs were there but people were oblivious to them. That is often the case with major economic events. People tend to focus on their immediate surroundings and pay no attention to the big picture. That ignorance may be fatal to your bottom line.
Some experts say the effect of QE2’s demise will be minimal and others insist that it will have broad implications. (WSJ Bog) Common sense suggests that interest rates will have to rise. If the supply of bonds increases the price will have to drop to attract buyers. As bond prices fall, interest rates rise. How far and how fast rates rise will impact the buying power of anyone using financing to secure investments or buy goods.
Am I suggesting that it’s time to panic? Not at all. However, you do need to pay attention to the overall economy since we are all a part of it. The supply of bonds could be reduced to keep prices up but that would mean that the government has to stop spending so much money that it just doesn’t have. While we’re at it, hell could freeze over, pigs could fly, and Elvis could make a comeback.
The government solution to a problem is usually as bad as the problem. – Milton Friedman
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