QE2: Likely Impotent

NEW YORK (TheStreet) -- After more than a month of expectation, QE2 time has finally arrived. Both debt and equity markets have been excited in anticipation despite the fact that no one really knows, including, it seems, the Fed itself, what the Fed intends to accomplish by bloating up its already pregnant balance sheet. There are likely to be serious unintended consequences.

Liquidity Trap

QE2 faces an economy in a liquidity trap. Monetary theory has always focused on the "M" in the MV=GDP equation, postulating that growth in "M" will impact GDP if "V", the velocity of money, stays constant. But, in a liquidity trap, an increase in "M" is offset by an equal decrease in "V" resulting in no new economic activity. The U.S. economy has observed a rapid decline in "V" over the past two years as the Fed has bloated its balance sheet. Excess reserves at banks have exploded while loans outstanding have continued to decline.

Thus, the Fed cannot be hoping that QE2 will spur loan growth. Given historic lows in interest rates, they can't be foolish enough to think that lowering them by a few more basis points will have more than a marginal impact. So, what can they possibly be thinking? The following comes to mind:

The "wealth effect"

Raised inflation expectations

A weaker dollar

The Wealth Effect

Over the last month, the announcement of QE2 successfully inflated equity prices. If QE2, the reality, doesn't disappoint, the "wealth effect" of rising equity values may cause rising consumer confidence and more consumer spending. Of course, that is a big "if." Even assuming that QE2, the reality, doesn't disappoint, studies of the "wealth effect" suggest that its impact is small compared to other policy tools. Thus, the size of QE2 would have to be gigantic to have a significant impact. The latest scuttlebutt from inside the Fed indicates that QE2 will not be "shock and awe." Thus, the impact of the "wealth effect" is likely quite small.

Inflation Expectations

Rising inflation expectations actually either raises interest rates and/or weakens the dollar relative to the currencies of its trading partners. Bill Gross of PIMCO recently postulated that QE2 will spell the end of the 30-year bull market in bonds precisely because increasing inflation expectations will add an inflation premium to bond yields across the yield curve. In a market struggling with a lack of demand, rising rates via inflation expectations, would be a negative unintended consequence. (Note: When interest rates are at or near zero, except for an anomaly or two of negative yields as witnessed with the Treasury Inflation Protected Securities (TIPS) auction, there is really only one way for rates to go, and eventually, they will go up. The only question for bond managers is "when".)

Weaker Dollar

The announcement of QE2 caused a near run against the dollar in the currency markets. Today's conventional wisdom says that a weaker dollar will cure the trade deficit and bring jobs back to the U.S. Unfortunately, it is foolish to believe that any improvement in the trade deficit caused by a weaker dollar will have any sort of immediate impact on U.S. jobs.

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