It’s risky to anticipate QE

Below is an excerpt from a commentary originally posted at on 17th June 2012.

Gold and “risk” assets rally whenever traders get the faintest scent that more QE (a central bank program designed to increase the money supply) is coming. Our view is that while more QE will eventually happen, buying in anticipation of such a policy move is fraught with danger.

Things are bad enough in the euro-zone (EZ) to justify* more QE at any time. Also, the rate of monetary inflation is low in the EZ, which lends support to the assertion that the ECB could do more good than harm by pumping money into the economy. However, the Fed is not in a position to implement another QE program in the near future, for the following reasons.

First, QE2 is widely (and correctly) perceived as a failure. In particular, a critical mass of people is aware that QE2 elevated the stock market and the cost of living, but did nothing to improve economic conditions for the average person.

Second, with the election less than 5 months away there would be a huge political backlash against the Fed if it initiated a new round of QE without an airtight excuse. To be politically feasible, the QE would have to be in response to a US (not EZ) economic emergency. To put it more clearly, things would have to get much worse for the US economy, the US stock market and/or the US banking system before more Fed QE would become a politically viable option.

Third, given the current grotesque size of its balance sheet the Fed would rather reduce than increase monetary accommodation. That’s why the actions it has taken over the past 11 months have changed the mix of items on its balance sheet but haven’t increased the balance sheet’s overall size. More QE would result in a large increase in the Fed’s balance sheet, which the Fed would prefer to avoid if at all possible.

Here is another point worth contemplating. Even if we make the dubious assumption that the Fed is prepared to adjust monetary policy to improve Obama’s chances of being re-elected, there is no guarantee that more QE over the months ahead would help achieve such an objective. It could actually achieve the opposite. This is because beyond knee-jerk reactions in all markets, there’s a realistic possibility that a new QE program would do nothing other than raise the prices of oil and gold (and silver — when we say gold we mean gold and silver) while the economy continued to weaken. In fact, the only price that would be sure to make a large and sustainable gain on the back of more QE is the price of gold. There was a preview of what we are talking about on 1st June, when much weaker-than-expected US employment data sparked the idea that more QE was on the way. Gold quickly rose $60 while the prices of most other assets fell.

As an aside, the Fed could take a backdoor approach to increased monetary accommodation by encouraging the commercial banks to lend more money into existence. This is something we discussed last year and could be done by cutting the interest rate paid by the Fed on excess reserves or, if that failed to provide sufficient incentive for the banks to put the reserves to work, charging the banks to hold excess reserves. This course of action could boost the money supply without drawing unwanted political attention to the Fed.

Summing up, the prices of many assets will probably move a lot lower between now and when the Fed announces a new monetary inflation program. Furthermore, if speculators ‘jump the gun’ and bid up asset prices in anticipation of future Fed-sponsored inflation they will eliminate the justification for the inflation. In other words, the more that prices rise in anticipation of a new round of QE the less reason there will be for central banks to implement a new round of QE.

The upshot is that there is a lot more to be lost than gained by making large purchases of anything in anticipation of QE. A more prudent approach would entail waiting for the formal announcement before establishing QE-related trading positions. The right positioning could then be determined based on market prices at the time.

*Creating money out of nothing is never justified by good economic theory, but there are times when it can be justified based on the flawed theories that dominate the thinking of most policy-makers.

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