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QE2: Beware the Perils of its Success

November 30, 2010

by Vitaliy Katsenelson

At some point quantitative easing will be followed by quantitative un-easing, as the Fed will have to sell all those bonds back, unless they are held until long-term maturity.  Either way, it will bring higher interest rates. 

QE2 is like a drug prescription that comes with a list of side effects that are often worse than the disease it was supposed to cure.  It is difficult to know all the side effects and unintended consequences of QE2, but it may result in a substantial decline in the dollar, stagflation, lower economic growth and much higher interest rates.  Inflation will show up not where the Fed wants it – in house prices – but in higher prices for commodities like food, gasoline, clothing, and electricity, which could kill consumption.  Yes, paradoxically QE2 may actually result in higher interest rates – investors expecting higher inflation will demand higher rates.   

Despite the Fed’s efforts, the dollar may not decline against the euro.  In this race to the bottom, the US may lose to the PIIGS rampaging through Europe. 

The Fed’s artificial manipulation of short-term and long-term interest rates creates a long-term problem for the economy.  Since interest rates are set by the 12 people in the Fed’s boardroom, the free market is not allowed to discover what interest rates should be.  The Chinese communist government has been under attack by politicians, the media, and even yours truly for manipulating its currency.  We know its currency is undervalued relative to the dollar and euro, but the Chinese government doesn’t let the free market know by how much. Government intervention (be it Chinese or US) in the free market creates excesses that are not allowed to self-correct and thus leads to bubbles. 

QE2’s possible success worries me more than its failure, because it will come with all the side effects I just mentioned, plus the eventual popping of newly created stock market and real estate bubbles.  The Fed wants to create asset bubbles, praying for the wealth effect – stock and real estate appreciation that will make people feel wealthier (at least on paper, for a while) so they will spend their phantom gains.  However, the Fed is like a Judas goat leading gullible (yield-deprived) savers to the slaughterhouse.  The paper wealth that is created will vanish as bubbles burst (they always do), wealth will be destroyed, and consumers will find themselves further in debt.

Japan was QEing from 2001 to 2006 and created a bubble in Japanese bonds that partially burst, but their economy did not lift out of stagnation.  Unlike our Fed, though, Japan stopped hiding its true intentions of propping up the equity market – on November 4th of this year the Bank of Japan announced it will be buying Japanese stock ETFs and REITs.

The Fed’s actions over the last two decades reminds of what Scarlett in Gone with the Wind used to say: “I can't think about that right now. If I do, I'll go crazy. I'll think about that tomorrow.”   The gains of today will be repaid dearly with massive overdraft fees “tomorrow.”