US Federal Reserve QE2 looks set to fail

Since the US Federal Reserve announced its US$900 billion 'QE2' programme of buying US Treasury debt and other mortgage-backed securities, stocks, bonds and commodities have moved violently in response. Looking at the intra-day actions on Wednesday and Thursday (US time), the market seems to be signalling failure of the new policy. Here's why.

Whatever the ostensible reasons for 'QE2', one important reason for the Fed's actions is to prop up the US stock market, using the 'reflation trade' to try to create enough wealth effect to stimulate household consumption, and thus get the US economy moving again. This is typical Keynesian thinking.

However, when we look at the market movements in the latter part of the week, we find that while US stocks have moved up, commodity prices have increased to an even greater degree. Since commodity prices influence cost-of-living, it means that the weak wealth effect has been more than negated by pipeline inflation. Thus, the market appears to me to be saying that the Fed's leveraging up of its balance sheet ultimately is a lot of 'noise' but no real impact is achieved. This is exactly what economists of the Austrian School have predicted together with some of the more savvy market participants.

For us here in Singapore, what this means is that we have to discount most of the 'good news' that the mainstream media is feeding us about the effectiveness of the Fed's latest policy move in helping the US economy to recover. The risk of a 'double dip' is still out there, probably in 2011.