QE2: This Time It's Serious

Published in Investing on 30 September 2010

Should we be afraid, very afraid, of more quantitative easing?

You know that old movie saying that the sequel is never as good as the original? Now we have a chance to see whether it applies to monetary policy as well, as we await the sequel to Quantitative Easing 1.

Just as The Terminator sequel was called T2, this sequel is known by the shorthand QE2. And it's coming to a central bank near you (provided you live in the US or UK).

So what do a Hollywood sequel and a second bout of quantitative easing have in common? Both are a licence to print money. But what will QE2 do for stock markets?

They're back

QE1 garnered mixed reviews. It is hard to say for sure whether QE1 bombed, because we don't know what would have happened to the economy if it hadn't been tried. But those blockbuster bond purchases didn't really achieve their goal of boosting the amount of money in circulation. 

Ben Bernanke and Mervyn King were scuppered by their nemesis, the bankers, who selfishly used their good fortune to prop up their balance sheets and bolster their capital reserves. They didn't want to do anything silly, such as lend it to business customers who might not survive the recession, or individuals who might not keep up with their mortgage repayments.

Still, if $2 trillion and £200 billion of bond purchases probably didn't work first time (and definitely didn't work in Japan nearly a decade ago), what the hell, why not try it again? You know what they say in Hollywood. Nothing succeeds like excess.

Play at your own risk

This time it's different. The first bout of QE was all about increasing the supply of money and fighting off deflation. This latest rehash has a different goal: to actively promote inflation.

The Federal Reserve has openly admitted it is unhappy with its inflation rate. It is, after all, just 1%. That's not much use if your total public debt is over $13 trillion, or 93% of annual GDP, and growing by $1 trillion a year. You need a lot of inflation to erode that, especially with the economy struggling to grow.

We knew QE2 was on the cards after the last Fed meeting, when it issued this statement: 

"Measures of inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."

And, um, repay that debt.

The Fed also make it clear it was "prepared to provide additional accommodation if needed" to support the recovery and inject more inflation (and expectations of inflation) into the system.

It didn't say how much it would spend on a second blitz of bond purchases, but there is talk of another $2 trillion worth.

London, we have a problem

Many thought QE2 wouldn't play here, because with RPI at 4.7%, we already have plenty of inflation. But where America leads, Britain faithfully follows.

We got the first hint this week, when MPC member Adam Posen said the Bank of England should "aggressively" buy gilts and mortgage books to prevent a lost decade of low growth and high unemployment.

Mr Posen didn't say "and debauch our currency as well", but guess what, the pound tumbled (again) the moment he finished speaking. It's amazing the impact of a few carefully chosen words to the Hull and Humber Chamber of Commerce can have.

Other MPC members may not be quite so enthusiastic, and why should they, with inflation high and the economy growing 1.2% in the second quarter, but this movie is now in pre-production.

The adventure continues

The US and UK don't just want to drum up inflation, they also want to hammer down their currencies. There is a global game of begger-my-neighbour's-currency going on right now, and everybody wants to join in (the noble eurozone excepted). If you mix this with growing inflation, things could get very messy indeed.

QE2 has already been priced into stock markets, keeping them relatively buoyant over the last few troubled weeks. Markets may remain buoyant after the virtual money is minted, particularly if this succeeds in ramping up inflation.

This could run and run

So what does this mean for investors? Well, it means another record high for the gold price, as investors lose faith in fiat currencies (again). It will also reduce the odds that the West will slip into a deflationary spiral, and boost the odds on significant inflation instead. 

You know what that means. Brace yourself for eventual interest rate rises. Flee cash and fixed interest and pile into inflation-linked bonds, commodities, commercial property and of course equities.

If we don't get QE2, that will either be because the economy is growing without further stimulus, or inflation is stubbornly high. Both could be good news for equities.

That assumes QE2 works, of course. There is always the chance that it may prove another turkey. After all, the original wasn't up to much.

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supasap 30 Sep 2010 , 10:28am

we're doomed when deflation sets in which it will through austerity measures all over the place... all assets will tumble

F958B 30 Sep 2010 , 11:22am

".....it means another record high for the gold price, as investors lose faith in fiat currencies (again). It will also reduce the odds that the West will slip into a deflationary spiral, and boost the odds on significant inflation instead......"

"......That assumes QE2 works, of course...."

If QE2 fails, they can soon launch QE3, QE4......eventually an entire battle-fleet of QE'S.
If "they" want to stop deflation, it is easy. History is littered with examples of currency devaluations to alleviate debt problems.
In fact, after most devaluations, the economy was soon powering ahead again, relieved of its debt burden at the expense of bond holders.
The big devaluation of the Dollar in the 1930's quickly stopped the deflation and ended the stock market bear. Interestingly, despite the big devaluation of the Dollar, inflation stabilised in single digits.

Luniversal 30 Sep 2010 , 11:49am

The rule of thumb in Hollywood is that a sequel only grosses 60% of the original's box office.

Does mogul Merv of BofE Pictures know better?

paulypilot 30 Sep 2010 , 12:09pm

Surely QE is actually a stealthy way of financing a massive budget deficit completely painlessly - simply print the money, and one branch of Govt buys debt from another! The need to boost the economy is purely a cover story IMO. The inevitable outcome from printing money is inflation & devaluation, it's just been delayed. Probably.

timthegambler 30 Sep 2010 , 1:07pm

Economics question: BoE buying gilts has what forecasted affect on the markets?

It drives up the price of gilts through increased demand, which decreases risk-free investments, therefore making it more appetising to invest in other assets?

Or am I missing the point, which is they print money to buy guilts, hence increasing money supply, decreasing deficit (through inflation) and attempting to stimulate lending?

If we expect inflation, is it a Foolish move to borrow money to invest (in non-cash assets), because inflation will decrease the present-value of debt??

healththenwealth 30 Sep 2010 , 2:35pm

Inflation: can't get too much of a "good thing" for the indebted state that we're in. It seems one of the lessons learnt from the Weimar Republic (apart from investing in wheelbarrow manufacturers) was that the main cause of hyperinflation is a massive and rapid increase in the amount of money that is not supported by a corresponding growth in the output of goods and services. (quote from wikipedia)

Roll on the comprehensive spending review, and hopefully we'll be able to pay off the debt by the time my children are drawing their pensions.

FXEconomist 30 Sep 2010 , 2:54pm

QE 1 , QE2, The Bank must have using cruise control.

PS For those who have not read it do look at

Drunsfleet 01 Oct 2010 , 3:54am

I'm skeptical about this idea that we can have inflation but not too much inflation.

If we have inflation we should allow deflation too - a natural correction? Why not a government target of zero inflation?

We have governments aspiring to be fiscally austere but monetarily debauched.

Fiscal liberality is a tax on the present and its electorate, monetary liberality is a tax on the future and its electorate - our grandchildren's children etc etc...an obvious politician's choice alas. A time-bomb waiting to happen - we just hope not in our lifetime. Shameful.

yogibear103 03 Oct 2010 , 11:11am

Can I ask the enlightened out there a simple question...? Exactly who or what does the world owe all this money to? Seems like every country in the world is in huge debt!!

supasap 05 Oct 2010 , 8:54am

hi yogibear, who knows? the evil ruling class? but if USA is so heavily indebted and she is richest nation in world then is there any chance for us? on a similar sentiment as yours check out Noddy Holder on "have i got news for you" programme when the credit crunch was breaking......

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