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QE2: Beware the Perils of its Success

November 30, 2010

by Vitaliy Katsenelson

In the midst of the 2008 financial crisis, to prevent the freezing up of the US financial system and possible bank runs, the Fed put in place QE1 – it purchased over a trillion dollars of mortgage and agency debt.  Like JP Morgan in 1907, the Fed was the lender of last resort.  But QE2 is drastically different from QE1, because the banking system is far from choking, and the Fed wants lower unemployment and the economy to grow at a higher rate. 

P.P.S. –The Vicodin Nation

Unfortunately, the Fed’s arsenal is missing the very important, must-have “do nothing” tool to fix the current problem.  This tool would let the economy self-heal, even if unemployment stayed at 10% while housing prices declined to their true level.  However, the tool is unlikely to be used, as it will inflict pain, something for which Americans have little tolerance.  After all, the most prescribed drug in the US is the painkiller Vicodin.  Regrettably, this is why QE2 is unlikely to be the last QE: as its effect wears off (assuming it succeeds at all), then QE3, 4 and so on will follow.  The US, like Japan, will be locked into unsustainably low interest rates. 

Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo.  He is the author of “Active Value Investing” (Wiley, 2007) and the upcoming The Little Book of Sideways Markets (Wiley, December 2010).  To receive Vitaliy’s future articles by email, click here His firm, Investment Management Associates, is looking to partner with financial planners/advisors to offer their unique portfolio management services to their clients.  They don’t do any financial planning; all they do is value investing.  You may contact him .