A SECOND QE WILL COST THE FED DEAR

 
David Morris
CFD MARKET STRATEGIST, GFT

The next Federal Open Market Committee (FOMC) meeting is a month away. Judging from the dollar, investors expect further stimulus from the US Federal Reserve. Equities began their current rally following the Fed Chairman’s speech at the end of August. Then, Ben Bernanke stated that the FOMC was ready to step in again and provide further monetary accommodation “especially if the outlook were to deteriorate significantly”. Just a few months earlier, talk focused on the best way for the Fed to reduce its balance sheet. But following a run of poor data, the odds on a strong US recovery were lengthening. It was also apparent that the private sector was in no state to drive growth.

So now, every disappointing number sees the dollar sell off and stocks head higher on an increasing likelihood of further quantitative easing (QE). There has been another shift in Fed language which suggests that a second round of QE could be launched even without an obvious weakening in data. Just over a week ago, FOMC vice chairman William Dudley said that given the Fed’s dual mandate of pursuing full employment while maintaining price stability, “the current situation is wholly unsatisfactory”.

St Louis Fed President James Bullard attempted to play down market expectations of QE2 in November. In an interview last Friday he said that the risk of a double-dip had receded, that a decision over QE2 would be a “tough call”, and that the first estimate of third quarter GDP would be important.

Equity markets have soared on the prospect of QE2, but investors have to ask themselves if this is the right response. After all, the first bout of QE was supposed to be the answer to the economy’s ills and comes at an high cost. Realistically, for the Fed to step in and plug the hole left as the private sector deleverages and pays down debt, it will take considerably more than a couple of trillion dollars.