I’ve spent a great deal of time analyzing and attempting to explain the possible ramifications of QE2 since it was first announced a year ago. My research led me to believe that there was no real substantive transmission mechanism through which QE2 could possibly impact the real economy given the current economic environment (balance sheet recession). But there was something else occurring as a result of QE2 and I believed it was causing severe distortions in the markets and resulting in a massive disequilibrium that threatened the real economy.

Before QE2 was inititated, Brian Sack, Executive Vice President of the NY Fed made the following statement:

“Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” (emphasis added)

Brian Sack and the other proponents of QE2 have justified the program in large part due to its portfolio rebalancing impact, wealth effect and other various market impacts. I have repeatedly stated that these effects are largely overstated and that the program was highly misguided, was misleading the public and likely resulting in a market disequilibrium that put the real economy at risk. In my opinion, false conclusions from decades of neoclassical economics has resulted in little to no distinction between markets and the real economy due to the efficient market hypothesis and the general belief that markets fairly represent the real economy. I think this is terribly flawed.

In my paper titled The Destabilizing Force of Misguided Market Intervention, I said:

“we are still at risk of a major dislocation due to the Fed’s severely misguided policy of QE2 and the market’s dramatic misinterpretation of it.”

What occurred when QE2 was inititated was one of the most fantastic market misinterpretations I have ever witnessed. A relatively harmless program (QE2 was nothing more than an asset swap with no true transmission mechanism that would alter either the private sector money supply, private sector net financial assets or the real economy) was incorrectly described as “debt monetization“, “money printing“, “stimulus” and other descriptions that implied QE2 was having a massive impact on the real economy through various channels. This couldn’t have been farther from the truth.

What QE2 definitively caused was a massive distortion in investor sentiment due to a general lack of understanding. Equities, commodities and other markets appeared almost entirely invulnerable as long as there was this belief that the Fed was backstopping the market. In other words, the Bernanke Put was in full effect. I have described the negative impact of the Bernanke Put on several occasions (see here and here) over the last year.

So what has occurred during QE2 is little to no real economic impact, but this massive psychological impact that has mostly impacted the markets as investors expected a certain real economic impact. As we all know now, that economic impact never materialized. So, prices were bid up as the Fed fueled the market with the misconception that it was achieving some real effect on the economy. But all this really did was generate a massive distortion.

In April I asked how the Fed was going to let the market down without causing a collapse in prices. But as equities collapse and wipe out the entire gains from QE2 it’s now clear that the market is quickly recognizing the true impact of QE2 – nothing. And the distortion and disequilibrium is resolving itself. Unfortunately, the Bernanke Put and such misguided policy creates no real economic impact, but distorts prices in such a manner that, when prices correct, the real economy can be substantially impacted as uncertainty, fear and volatility cause disturbances in the real economy. So in an interesting sort of way, QE2 is doing more harm than good.

In addition, one of my greatest fears as a result of QE2 is that the Fed is hurting its credibility via its own misinterpretatons of this program. Last November I said:

“The Federal Reserve has placed its credibility at risk while also creating market distortions due to misconceptions surrounding a policy that very few people actually understand. This is not only unhelpful in solving the actual cause of the current crisis, but creates extreme disequilibrium in markets that only makes matters worse.”

Make no mistake. The current market collapse is not merely a coincidence. It is the direct result of the fact that the Fed created a distorted market environment. The current economic weakness and other global instabilities are merely an excuse for the collapse we are now seeing around the globe. And now the Fed has to accept the fact that their policies have helped contribute to the slowing economy.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  1. Isn’t it true that QE was electronic money creation? In other words, the assets that the fed swapped for treasuries were created ex nhilo (electronically) by the Fed? Am I mistaken about that? If I am not mistaken, then where did the money come from to purchase the treasuries?

    • The Fed has, at all times, an infinite cash asset, yet we don’t have infinite inflation because that cash is dormant.

      By swapping TSYs for some of this infinite cash all that happened is that the TSYs became dormant at the Fed alongside the infinite cash asset.

      Net assets outside the Fed didn’t change in value, only in flavor. (TSYs transformed into cash).

      The whole process is sterilized because when the Fed sells its TSYs back to the market, the cash it gets in exchange goes back into dormancy with all the other infinite cash.

      In addition, because TSYs earn income, the Fed injects it back into the external world in order to preserve how things would have been if the TSYs were still out there. This is achieved by the Fed handing over income earned to the Treasury. Another way the Fed can divest itself of unwanted profits (it would be deflationary if the Fed sat on them), is for the Fed to pay them out as interest on reserves.

  2. Really good analysis Cullen, and you are not alone. I saw one analyst on Bloomberg today that said basically the same thing. Don’t remember his name but he was on the noon hour program with Tom Keene. I have also read a few other analysts that are in agreement with you in that it was not “money printing”, but that the Wall Street group believed that it was and that was what led to their belief in the “Bernanke Put”.

  3. As the US debt-to-GDP ratio rises towards 100%, policymakers will be tempted to inflate away the debt. This column examines that option and suggests that it is not far-fetched. US inflation of 6% for four years would reduce the debt-to-GDP ratio by 20%, a scenario similar to what happened following WWII.


  4. No way to use inflation (at least at that level); no demand is available for that, money flow is not going down, to the mass. In other hand we cannot go in this direction, we should downgrade the entirely Western Countries asset through FX – currency devaluation, first USD then Euro to equilibrate the demand/offer balance. US has absolutely enough potential to pay its debt in USD as soon you want, but not before USD is going down enough, EUR is deleveraging its social-system to find the equilibrium. Inflation must be in synchrony with salaries rising and low cost-import-commodities (raw materials)… as it was after WWII….. and that’s is exactly the opposite they are looking for…… it has a point, and we are not ready yet…

  5. The Bernank understands all this just fine. He knows QE is not truly effective, that it distorts markets and ultimately may do a lot of damage – especially to the Fed’s credibility.

    The reality is that QE2 was a hail-Mary.

    The Fed is out of bullets.

    (They used the last one on themselves)

  6. Could this be the transmission mechanism? I came across this statement at http://www.contraryinvestor.com/2011archives/mojun11.htm :
    “Although it’s just our perception, the banks used the money to trade the financial markets (remember that banking system excess reserves can be used as collateral for futures and derivatives contracts – how convenient).”