Today we’re going to ponder Quantitative Easing a bit. There are a lot of folks thinking that we get QE3 out of Jackson Hole today. However, the reasoning appears to be simply because they want to see the economy stimulated.

Don’t get me wrong. I’d love to see the economy get stimulated as well. However, there are two problems with this thought process.

On one side, QE does not truly help the economy. All it does is offer a quick fix for a cash flow addict. Cut off the flow and the patient will go into spasms, draining their life until they finally reach a point of desaturation. Only then can the patient hope to regain true health. But, until that happens, people will continue to cry out for whatever offers relief for their immediate concerns, regardless of the long-term repercussions.

On the other, while the underlying issues with the economy are dire indeed, on the surface it simply doesn’t look that bad. And, until it does, we shouldn’t expect QE. That’s not to say it won’t in the near future. In fact, I fully expect a severe pullback in the next month; one that might precipitate QE3. And the timing, leading right up to elections, seems too perfect.

In pondering QE, first let’s examine a definition. Then let’s examine the chart below. Investopedia offers this definition and explanation:

• Definition – A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital, in an effort to promote increased lending and liquidity.
• Explanation – Central banks tend to use quantitative easing when interest rates have already been lowered to near 0% levels and have failed to produce the desired effect. The major risk of quantitative easing is that, although more money is floating around, there is still a fixed amount of goods for sale. This will eventually lead to higher prices or inflation.

If you’d like an explanation in layman’s terms that is easier to understand, check this out.

In the attached 5 year chart we have the dollar and S&P, with QE1 and QE2 represented by the pale bands. QE1 was announced on November 25, 2008, in the midst of the financial crisis that began to unfold the previous year. Of course, the gears were put in place for this tumble over a period of many years. But the piper called in 2007, and real estate was in his sites.

The rising dollar and precipitous fall of the major indices revealed a massive deflationary trend that is the arch enemy of central banks. In an effort to keep interest rates low and stimulate the economy through greater money velocity, the Federal Reserve began to purchase debt. And, again, for the short term, it worked.

As you can see from the chart, the dollar began dropping in value and there was a momentary pop in the S&P. However, this was short lived, as the pressure on the economy was too great for initial efforts to overcome. Even after cutting interest rates in December, the dollar continued climbing and stocks fell.

In March, 2009, the FED took on more debt, this time with the economy responding as hoped. By the end of QE1, in March, 2010, the S&P and almost doubled from its lows and the dollar seemed to find some equilibrium.

Since the economy still appeared anemic, the FED continued to make efforts to promote growth. In spite of the fact that all historical efforts of QE had failed, especially as exemplified by Japan, QE2 was announced on November 3, 2010.

The result was anything but what was expected. The drug simply doesn’t work as well the second time around. This time mortgage rates increased and the dollar popped up initially. However, the S&P did increase steadily over the next several months and the dollar dropped, signaling inflation.

So, why QE3 today? The economy continues to languish, but is it really time to attempt to stimulate it? As can be seen in our chart, though the dollar has increased, it’s not showing signs of continued immediate growth. Furthermore, stocks are doing fine. In fact, we’re at annual highs right now.

Because of the capriciousness of the economy in light of QE, the diminishing returns of QE and the expectations many have for QE, it seems that QE this week is simply not going to happen. Furthermore, it appears that expectations have already priced in QE3. Perhaps today’s drop is a reflection of this, as people’s expectations are waning.

What to expect? If today’s drop is a result of waning expectations, we should see a pop up in the markets on the tail of Ben’s speech. However, I wouldn’t expect this to be sustained as the market realizes there is no stimulus to come in the following weeks.

On the other hand, with such realization should come a strong pullback and a pop in the dollar. This may indeed precipitate QE3 in the near future, perhaps as early as late September or early October.

For now, expect metals to flow with the stocks. That’ll change eventually, but investors seem content to let them ride together for now. If the above scenario takes place, we could see new highs in both stocks and metals before the end of the year, or perhaps early 2013.

For your prosperity,

J. Keith Johnson
The Gold Informant