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Quantitative Easing: Knowing When to Say When

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It was just three short years ago that you could throw a dart and likely pick a winner; then reality struck! The real estate bubble collapsed, credit markets dried up, and poor investment decisions brought down some of the largest financial institutions.

The Federal Reserve, in its best efforts to contain this maelstrom, chose to inject money into the financial system in an attempt to boost liquidity and spur consumers to buy. By all accounts, so far, despite the government's buying some very poor assets from some of the nation's largest banks, this original quantitative easing accomplished its goal. People were buying stocks again, and the banks had ample liquidity to lend.

Last week, the Fed announced that it would undertake its second round of quantitative easing, aka QE2, beginning now and ending in the second quarter of 2011. At stake is another $600 billion, which the Fed will essentially print out of thin air and use to purchase U.S. Treasuries in order to lower long-term interest rates and drive an economic recovery. Putting hope aside, my thoughts are that Chairman Ben Bernanke and the Fed have made a costly long-term error.

Spare some change?
First, it's very unlikely that we'll be able to see the long-term inflationary effects of this quantitative easing for some time. Blindly printing money to spur the market could wreak havoc on commodity prices, as fellow Fool Dan Caplinger points out.

Gold, silver, oil, coffee, corn, and cotton are all at or within reach of multiyear highs, which spells trouble for both your pocketbook and company expenses. At Wal-Mart (NYSE: WMT  ) , rising gold prices could eat into jewelry margins and push prices higher. Kroger's (NYSE: KR  ) margins may suffer from rising food prices if it does not pass that increase to consumers. Likewise, rising coffee prices have necessitated Starbucks' (Nasdaq: SBUX  ) raising its prices. No matter how you look at it, margins are being squeezed and everyone suffers.

Hello staycation!
Even more problematic is the negative impact  QE2 has on the U.S. dollar. Sure, a lower dollar helps in the short term by making U.S. exports considerably more competitive, but it makes it considerably harder for Americans to travel. Fewer people taking vacations and a rising inflation scenario might spell trouble for a company like Carnival (NYSE: CCL  ) , which relies on a steady stream of vacationers and lower fuel prices to be profitable.

The double whammy is that if you decide not to travel, since oil is often denominated in dollars, and dollars are weakening, the cost of oil and gasoline may rocket higher, trapping you in a no-win situation.

Looking at QE2 from a foreign perspective makes this look even bleaker. By printing money, the U.S. is devaluing its debt by driving down the price of the dollar. China and Japan purchasing U.S. debt has been one of the few bright spots up until now, but if future debt purchases are going to be met with continued devaluations, it's possible that these countries may look elsewhere with their capital. Not only could this stymie U.S. growth, but as I mentioned earlier, increased U.S. exports could hurt growing economies like China.

House of cards
Housing could be one outlying factor that could be at the heart of QE2. The Fed injected $1.25 trillion into various economic instruments meant to buoy the banks behind the mortgage crisis in 2008-2009 and I highly doubt they'd let that money go to waste. By driving down Treasury yields, the Fed will hope to artificially enhance the "wealth effect" by causing investors to jump into stocks and potentially move the overall market higher.

The problem here is that the housing market simply can't be buoyed by artificially pumping money into the system. Eventually the market needs to account for the massive glut of foreclosures and the continued slide in housing prices. Until the market can genuinely cope with the reality of the housing market, I doubt QE2 can successfully create wealth given how most Americans' wealth is tied to their homes.

I also find the timing of QE2 to be suspect given that we're seeing the highest rate of variable-rate mortgage resets in three years. This time we'll be fine from a liquidity perspective, but with homebuilders taking writedowns on large inventories -- such as KB Homes (NYSE: KBH  ) , with $129 million so far this year, and D.R. Horton (NYSE: DHI  ) with a writedown of $31 million in its latest quarterly report -- it's a sign that the market hasn't properly adjusted itself yet. A steady stream of foreclosed properties on the market simply will not allow these excess homes to sell.

Final Foolish thoughts
The Fed and Bernanke appear to be in the driver's seat, with their blinders on and heavily under the influence of the artificial wealth effect. Just like the commercials warn you, sometimes you have to "know when to say when," and Ben Bernanke, QE1 was more than enough!

Related Foolishness:

Fool contributor Sean Williams does not own shares in any companies mentioned in this article. You can follow him on CAPS under the screen name UltraLong. Starbucks is a Motley Fool Stock Advisor selection. Wal-Mart is a Motley Fool Inside Value choice and a Motley Fool Global Gains recommendation. The Fool owns shares of Wal-Mart. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

Read/Post Comments (7) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 22, 2010, at 4:15 PM, negrodamus wrote:

    Sean, you're pretty much on target here, but you're forgetting one thing - how on Earth is GS supposed to make ridiculous amounts of money without this?? Face ripping is getting hard these days, and I'm sure Ben's help will be greatly appreciated.

  • Report this Comment On November 22, 2010, at 4:21 PM, Harker207 wrote:

    Best summary of QE2 can actually be found in a video, of all places...

  • Report this Comment On November 22, 2010, at 5:44 PM, starfish36 wrote:

    You continue to worry about inflation when the available data strongly suggest that deflation is by far the greater problem and greater concern. The editorials of Nobel Laureate Paul Krugman in the New Times, which can be downloaded anytime, make the point much better than I can, particularly in the limited space here. Beyond that, Bernanke isn't printing anything, much less "blindly" printing it. Bernanke and Krugman are among the best authorities in the world on the Great Depression. Be happy you have Roosevelt and not Hoover running the Fed. And check out the price of natural gas, among other commodities. It's very low.

  • Report this Comment On November 22, 2010, at 7:29 PM, TMFBent wrote:

    The fallacy about "printing money" leading to inflation is persistent, and doesn't take into account the velocity of money. I've written about this in the past, ineloquently, and others have discussed it with a lot more rigor. But it's not very fashionable to defend loose money policy these days, with everyone predicting inflation despite the lowest inflation rate on record.

    Record prices in commodities aren't a concrete indicator of the inflationary outcome of loose money policy. We had that just before the real financial collapse as well. It was a bubble, nothing more, and those are by definition irrational and unpredictable.

    I used to be on the side of the inflationists. My problem is that I'm willing to change my opinion when the facts change, and they've been changed for a couple of years now.

  • Report this Comment On November 22, 2010, at 11:21 PM, PostScience wrote:

    The US trade deficit is staggering. Treasuries are trading near all-time highs. Inflation is near all-time lows.

    If there was ever a time for qualitative easing, it's now. Is this author on the payroll of the Chinese government? If not, what is he smoking?

  • Report this Comment On November 30, 2010, at 1:05 AM, rfaramir wrote:

    "I doubt QE2 can successfully create wealth" True. It can only redistribute it, and less efficiently than the free market.

    Former Enron advisor Paul Krugman is not trustworthy. His false economics prompted him to beg the Fed to create a housing bubble to replace the burst tech bubble.

    Printing money IS inflation. The money supply inflates, but rising prices, the inevitable result, does not happen immediately. The Fed does not find every holder of US dollars and give each one an additional (say) 0.8% of however much they currently hold. They print, stealing the purchasing power of dollar holders, and exchange these legal counterfeits for Treasuries, rewarding bankers and government, who then spend on their needs and wants which then trickle the new money into our hands, raising prices unevenly throughout the market. Those who get the new money first, before prices rise, benefit most: bankers, bureaucrats, and debtors. Those who get it last, after prices have already risen, are hurt most: seniors, creditors, savers, wage earners.

    If you continually hurt the moral (thrifty) and reward the immoral (statist tyrants and bail-me-out-again bankrupts) you will eventually damage the heart of your country.

    "The US trade deficit" is immaterial. We got goods, they got dollars; the same value went both ways across the borders, therefore balancing perfectly. The problem is that our dollars are a promise of future American goods, and we are hell bent on breaking those promises by devaluing the dollars or even defaulting on our bonds.

  • Report this Comment On December 02, 2010, at 12:12 AM, crca99 wrote:

    thx for explaining QE2

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