Earlier this week, a colleague of mine wrote a good post about how a further round of quantitative easing from the Federal Reserve could affect mortgage rates. For those who don’t know, quantitative easing is a mechanism by which the Federal Reserve increases the money supply. The Fed does this by creating money out of thin air, which it then uses to buy assets (in this case, the Fed will probably buy Treasuries). This transfer of cash into the economy is supposed to give banks excess reserves, and this excess is slowed or deposited in the economy, in the hope of stimulating growth.

In a speech today, Fed Chairman Ben Bernanke seemed to indicate that economic conditions warrant further QE by the Fed (this would be the second major round of QE, hence the nickname QE2). Bernanke said:

“Given the Committee’s objectives, it would seem that, all other things being equal, there would be grounds for further action. However, as I indicated above, one of the implications of a low inflation environment is that policy is more likely to be constrained. due to the fact that nominal interest rates cannot be reduced below zero.In fact, the Federal Reserve lowered its target for the federal funds rate to a range of 0 basis points to 25 basis points almost two years ago, in December 2008. with the overnight interest rate at zero, but unconventional policies have costs and limitations that must be taken into account when judging whether and how aggressively to use them.”

This is not really a surprise to anyone. Analysts and pundits have been waiting for a second round of quantitative easing for quite some time. The economy is growing much slower than the Fed’s growth target of 2 percent. While some Fed governors (such as Thomas Hoenig of the Kansas City Fed) oppose further QE for fear of inflation, that view appears to be in the minority.

So the big questions are: will this stimulus work and what effect will it have on mortgage rates? The second question is the easiest to deal with, so let’s start there. Theoretically, additional Federal Reserve bond purchases should drive mortgage rates lower. The additional demand for Treasury notes created by the Fed’s purchases should cause Treasury note prices to rise. This will cause the yield on these bonds to decrease. Mortgage rates generally follow Treasury yields, so if yields decline, so should mortgage rates. However, we have seen mortgage rates hit all-time lows over the last four weeks. It is quite possible that QE2 is already included in the price of the bonds, as everyone is waiting for it to happen. If this is the case, mortgage rates could only move significantly if the size of the stimulus is much larger or smaller than what the market expects.

Whether or not QE2 will succeed in stimulating the economy is a more difficult question, and I left my crystal ball at home today. Paul Krugman of the New York Times has suggested that we need $8-10 trillion worth of QE. This seems unlikely to happen. Opinions on the effectiveness of monetary policy in alleviating our current situation vary. Interest rates have been near zero for over a year and the economy is still struggling. Only time will tell, but it’s quite possible that the Fed is simply pulling a string here. The next Federal Reserve meeting will take place on November 2-3, so we will know more at that time.