Wednesday, November 3, 2010

Forget the Elections; The Rest of the World Hates QE2

While we Americans were focused on the midterm elections, the rest of the world is focused on the Fed.

Bill Gross of Pimco yesterday warned that the U.S. dollar might depreciate by 20% over the next couple of years if the Fed aggressively pursues its second round of quantitative easing (QE2).

Gross joins other prominent investors like Buffett and Soros in questioning the effectiveness of another round of monetary easing, especially when the possible risks to a QE2 strategy are taken into account.

Personally I'm not sure what adding another $500 billion or so in monetary stimulus to a system already awash with liquidity will accomplish. That said, I'm afraid that the Fed is the only player in Washington that has the stomach for some sort of economic stimulus. Yesterday's election results make any sort of fiscal stimulus essentially impossible for the next couple of years.

Meanwhile, the rest of the world - which, by the way, are our creditors - are furious with the U.S. policy. Consider this excerpt from Ambrose Evans-Pritchard's column in yesterday's London Telegraph:

China's commerce ministry fired an irate broadside against Washington on Monday. "The continued and drastic US dollar depreciation recently has led countries including Japan, South Korea, and Thailand to intervene in the currency market, intensifying a 'currency war'. In the mid-term, the US dollar will continue to weaken and gaming between major currencies will escalate," it said.

China, of course, has about $2.5 trillion of dollar-based assets, which would obviously be seriously eroded in value if the dollar nose-dives.

But it's not just China. Our benign neglect of the value of the dollar is driving prices higher around the world, causing central banks in countries like Australia to tighten their own monetary policy. More seriously, food prices for many developing countries have soared, whacking poor countries:

The innocent bystanders caught in the crossfire of Fed policy are poor countries such as India, where primary goods make up 60pc of the price index and food inflation is now running at 14pc. It is hard to gauge the impact of a falling dollar on commodities, but the pattern in mid-2008 was that it led to oil, metal, and grain price rises with multiple leverage. The core victims were the poorest food-importing countries in Africa and South Asia. Tell them that QE2 brings good news.

I don't know what the Fed has planned - I guess we'll learn more this afternoon, and in weeks to come. I continue to believe that any significant monetary stimulus sets us up for a decent stock market rally over the next few months, as well as lower interest. It may also push up the value of gold, as investors across the globe flee paper currencies.

Longer term, however, I am not convinced that simply depreciating our dollar will solve all of our economic woes. Moreover, at some point, the Fed will have to consider withdrawing some of the massive monetary medicine it has been administering, or risk huge inflation risks at some point in the future.

QE2 risks currency wars and the end of dollar hegemony - Telegraph