QE2: 3 signs to watch for progress

November 17, 2010, 10:42 PM UTC

Will it or won’t it work? Here are some ways to find out.

Many economists and market commentators are convinced that the Fed’s move to pump $600 billion into the economy by buying up long-term bonds will do more harm than good for America’s economic recovery.

Quantitative easing, as it’s technically called, is rarely used by central bankers to boost the economy. So while the Fed’s last-ditch policy prescription might be well intended, the outcome is still very much uncertain.

If it’s successful, a few things would happen: Businesses drawn to lower interest rates would borrow, leading them to invest and hire more. Asset prices including stocks would surge and boost consumer confidence. Consumers, particularly homebuyers attracted to record low mortgage rates, would borrow and spend more.

But then again, things could go terribly wrong, and it appears the criticisms are mounting. With so much newly printed money in the financial system, critics charge that quantitative easing could destroy the value of the US dollar. Meanwhile, world leaders worry the new money could hurt their economies, creating market bubbles that would destabilize their financial systems. What’s more, export-rich countries including Brazil and Germany worry the Fed’s asset-purchase plan could hurt sales of goods and services abroad as the strengthening of their currencies would make exports less competitive.

Some even argue the first round of quantitative easing turned out to be a flop when officials purchased about $1 trillion in Treasuries during the height of the financial crisis in March 2009. So why would another flush of cash work?

Regardless, the point is it’s much too early to tell if the Fed’s plan will help. As officials buy up Treasuries over the next eight months or so, Fortune lists three indicators to watch for signs that it’s working:

Rising business investments

It’s one of the cheapest times for companies to borrow and invest these days. And yet, while some of the biggest corporations including Microsoft (MSFT) and Wal-Mart (WMT) have taken advantage of the low rates, it appears that the new money isn’t translating into new jobs.

It’s true business investment has fared better than consumer spending following the Great Recession that started December 2007 and ended June 2009. In particular, since mid-2009, there’s been an upswing in companies replacing aging software and equipment. But business investment is still far from the levels seen prior to the latest recession.

Meanwhile, companies aren’t exactly borrowing much more, even while interest rates have dropped to record lows, and many of the companies that have locked in low rates are just refinancing existing debt – not exactly borrowing new funds and investing them. The latest to do that was Coca-Cola (KO), which recently sold $4.5 billion of bonds in its biggest offering ever, a portion of which went for a coupon of just 0.77%.

Part of the goal of quantitative easing is to spur investment through lower interest rates. Purchases of new equipment and software, which typically makes up two-thirds of business investment, had been steadily picking up since around mid-2009. It rose to 24.8% during the three months ending in June 2010, but has cooled during the latest quarter to 12% growth amid signs that the economic recovery is slowing.

What’s more, it remains to be seen how much of the newly printed money falls in the hands of small business owners. Though lending conditions have eased some and owners seem more concerned about consumer demand than borrowing more funds, new capital is nevertheless an important component for expansion and more hiring.

More home purchases and refinancing

Even before the Fed unleashed a second round of freshly printed money into the economy, U.S. mortgage rates dropped to record lows. Rates are expected to stay relatively low following the Fed’s policy action.

It’s one of the cheapest times to borrow but it’s not as if consumers are flocking to cash in on low interest rates. A frenzy of new home loans and refinancing would surely help reduce the excess stock of residential units on the market, raising prices and helping homeowners recoup some of the equity lost on their properties. And while more refinancing might not immediately provoke the debt-weary consumer to start spending much more, it would certainly help them de-leverage and recover from the old days of too much spending.

In its latest report for the week ending November 11, Freddie Mac (FMCC) reported rates hit its lowest since at least 1971. The rate for a 30-year fixed loan fell to 4.17% from 4.24% the prior week.  On average, the 15-year rate declined to 3.57% from 3.63%. Despite record low borrowing costs, the plethora of underwater mortgages, tighter lending standards and general disinterest seem to have kept borrowers from refinancing. At least half of mortgage holders still pay 5% or higher in interest, regardless of whether a fixed or floating rate. What’s more, low interest rates have yet to spark a buying spree of homes.

The “wealth effect”

A fall in interest rates generally causes asset prices including stocks to rise. This is good for shareholders. But as Barry Ritholtz points out, the vast majority of Americans’ wealth isn’t exactly tied to the stock market. Quantitative easing might make the stock market rally but the equity market is overwhelmingly concentrated to the top 1% of Americans who own about 38% of stocks (by value) in the US, Ritholtz writes. He adds that most Americans have less than a 10% stake in the stock market and that the majority of their investments are still tied to their homes.

So will the rise of stock prices ignite a flurry of consumer spending? Ritholtz thinks it’s highly unlikely. In the coming months, it remains to be seen if stock prices will influence the consumer psyche, which is still preoccupied by debts, home values and job prospects.

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