THE UNINTENDED CONSEQUENCES OF QE2

It looks like the Fed is already beginning to worry about the unintended consequences of QE2.  In a speech earlier this week Richard Fisher discussed an important consequence of QE.  He said:

“In my darkest moments, I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places.”

It certainly is working in the wrong places.  While the Fed creates paper profits in stocks and bonds QE appears to also be influencing the price of commodities.  Commodity prices have surged in recent weeks as the Fed has driven the dollar lower.  What’s so pernicious here is the margin compression that Gaius discussed the other day.  This is crucial because the margin recovery has been the single most important component of the equity market recovery.

What’s so interesting here is that Ben Bernanke might actually be creating a double headwind for the economy in the coming quarters.  Not only is he reducing margins for many corporations, but because quantitative easing is inherently deflationary (because it replaces interest bearing assets with non-interest bearing assets) it is not helping aggregate demand. From the perspective of a corporation this means stagnant revenues and higher input costs.  That will only increase the reluctance to hire.

Of course, the Fed thinks they can prop up particular markets and generate a “wealth effect” that is unsupported by the underlying fundamentals.  Interestingly, in the long-run, Mr. Bernanke might be creating more damage than he even understands.  But at least someone at the Fed is beginning to wonder if this strategy is viable.