Has any proposed shift in Federal Reserve policy ever left so many market strategists, investors or economy watchers as confused as the second coming of quantitative easing expected next week?
Investors in all sorts of asset classes from stocks, bonds and currencies to commodities and real estate have been tying themselves in knots trying to guess the probable impact of QE2 on U.S. economic fortunes, inflation, interest rates, the price of oil and the exchange value of various currencies.
Watching market reaction in the past few weeks is akin to studying mice in a maze running to and fro while the researchers keep moving the cheese. After weeks of gains based on anticipation of QE2, stocks and commodities have started turning the other way.
And the U.S. dollar, which seemed to be heading into banana-republic territory, is suddenly reviving. One reason: a Wall Street Journal article on Wednesday noted that the Fed easing will be gradual. The central bank will purchase a few hundred billion dollars worth of long-term U.S. Treasury bonds over several months [the best guess is about a six-month buying binge] in an effort to boost prices and bring down already low interest rates.
Is this really a surprise? Did anyone seriously think that Ben Bernanke and his crew were about to flood the market with a trillion bucks or so in one shot? The QE-or-bust crowd already faces internal opposition from a handful of the dozen regional Fed bank presidents; but only one of them has a vote this year on the 10-member policy-setting Federal Open Market Committee. That would be Thomas Hoenig, who heads the Kansas City branch and is becoming something of a folk hero for his adamant objection to easier monetary policy.
His latest comments on Monday nicely sum up his views. He called QE "a very dangerous gamble" and a "bargain with the devil," reiterated his belief that interest rates should be going up, not down, and likened the current approach to Fed policies in the early 1970s that paved the way for a severe bout of stagflation.
Mr. Hoenig is not the only one raising the red flag of inflation, which, on the surface, seems far-fetched, given the deflationary forces now at work in much of the developed world. Eduardo Lopez, who carries the impressive title of senior oil demand analyst (does he have a counterpart on the supply side?) with the International Energy Agency, warns that "QE2 could inflate prices in nominal terms and bring about inflation and could derail the [global]recovery."
Mr. Lopez's fear is based on the fact that a weaker dollar means higher prices for commodities such as oil and metals that are priced in the U.S. currency.
It was all too much for the biggest booster of more monetary easing and fiscal stimulus in the world of economics. That would be Paul Krugman, the esteemed and increasingly steamed Nobel Prize winner and New York Times columnist. Without actually naming Mr, Lopez in a Wednesday blog item, Prof. Krugman annoints him as the world's worst economist -- or at least someone who doesn't know any better than a first-year student of the dismal science.
"Higher commodity prices will hurt the recovery only if they rise in real terms. And they'll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.
"What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales."
But is the concern about inflation down the road entirely misplaced? Not from where influential bond investor Bill Gross sits.
Cheque writing "in the trillions is not a bondholder's friend," the manager of the world's biggest bond fund says in his monthly investment note (on Pacific Investment Management Co.'s web site, PIMCO.com). "It is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. It raises bond prices to create the illusion of high annual returns, but ultimately it reaches a dead end where those prices can no longer go up."
In any case, few economists think QE2 will have any noticeable effect on the U.S. recovery. Interest rates are already at historic lows, Banks have plenty of capital to support renewed lending, should they ever get the urge again; and corporations have all the cash they need to expand if demand ever picks up. Unfortunately, that's not something that will be fixed with looser monetary policy.
As for me, I tend to side with Dylan Grice, the contrarian global strategist with Société Générale, who told me recently: "Never underestimate the ability of governments to totally screw things up."Report Typo/Error