Many clients have asked for our thoughts on Quantitative Easing Part 2 – QE2, not Queen Elizabeth II.  What is QE2, you ask?   QE2 is the Federal Reserve’s plan to inject $600 billion dollars into the financial system by purchasing Treasury Notes.  The Federal Reserve is buying notes issued by the Government in an attempt to provide stimulus to the economy.  It is doing so in an untested manner.  We believe the ultimate goal of Ben Bernanke (who is an expert on the Great Depression) and his friends at the Federal Reserve is to fight the threat of deflation.  If deflation becomes ingrained in the psyche of the public, it is very, very hard to fight.  One only has to look at Japan over the last 20+ years to see how deflation hurts an economy and a stock market.

Some will ask, but doesn’t adding all this cash to the U.S. economic system cause inflation?   The answer is – it depends.   The two major sources of inflation are wages and real estate.    With the national unemployment rate close to 10% and real estate foreclosures at record highs, we don’t see inflation coming from these two sources anytime soon.  The Federal Reserve has added a lot of liquidity to the system in the last 18 months.  This has allowed the banks and the banking system to heal.   That is a good thing.  However, now that the banks are healed and are in a position to lend, they have no one to lend to.  Banking standards are very high right now compared to where they were 2 years ago.   Those that need money can’t get it because they have low credit scores and those that have good credit ratings don’t want to borrow so the cash that has been injected into the system is just sitting in the banks.  If money does start flowing from the banks to the end users, it would be very inflationary.   We are watching lending standards and the velocity of money (how fast money is going through the system) as an indicator of future inflation.   The velocity of money is creeping up a bit, but is not anywhere near the levels needed to spark inflationary concerns.

So what scares THOR about QE2?   First, we don’t know if it is necessary because the money supply has actually been growing the past few months as business has been improving for most industries.  Second, the Federal Reserve is financing the government directly – it has not done this before.   This causes uncertainty and that alone has unintended consequences which we are not aware of as of yet.   Third, and most importantly, politicians now want more control and oversight over the Federal Reserve.   This is not a good thing.   You pick your favorite (or least favorite) politician and honestly ask yourself if you want those individuals making monetary decisions.   If the politicians wrestle more control from the Federal Reserve, it would cause uncertainty and give them more power to manipulate election cycles by pumping or draining money from the system.   That should scare everyone.

Sincerely,

Your THOR Team