The Fed’s policy of Quantitative Easing (“QE”) in the wake of Lehman’s bankruptcy and the subsequent financial crisis was aimed at providing a substantial pool of liquidity to restore confidence in the financial system. The latest round of QE (dubbed “QE2”) is aimed at spurring economic growth.

Whether QE2 is necessary or will work has been debated to death. What’s been missing from the debate is a shadowy undercurrent and what may be the true goal of QE2 – winning a war with the Chinese that’s taking its toll on US budget and trade deficits.

Before understanding how QE2 seeks to counter the Chinese let’s clarify what is QE. Quantitative Easing is a monetary policy used by some central banks to increase the money supply by increasing excess reserves in the banking system. This is generally accomplished by the purchase of the government’s bonds to raise their prices and, conversely, lower their interest rates. It’s analogous to electronically printing money and is often inflationary.

To date the Chinese with their currency peg to the Dollar have run up a massive trade surplus with the US which has failed miserably in its attempts to convince the Chinese of the need for a freely floating Yuan. The Chinese argument has been a floating currency would create significant domestic problems (which, implicitly, argues that it’s better for the US to suffer due to an overvalued Yuan than for the Chinese to suffer by fairly valuing the currency).

QE2 speaks directly to this issue. The Fed’s issuance of electronic currency to buy Treasuries will depress the Dollar (despite the Washington rhetoric of a “strong Dollar policy”) which, in effect, weakens the Dollar-pegged Yuan. The resulting change in price levels (a decrease in inflation-adjusted or “real” purchasing power) makes US goods more affordable in China providing a favorable impact to the US trade deficit.