A QE2 Quandary

Story Highlights:

• QE2 is slated to end this June, and there’s already much discussion of Fed policy’s future direction.
• The various views held depend largely on one’s opinion of current US economic conditions.
• The debate’s just getting started and may contribute to heightened market volatility in the coming months.
• Regardless of the outcome, it’s unlikely to derail continued economic growth in 2011.

QE2’s impending end in June has many attempting to draw early conclusions on its efficacy and determine next steps. Given the Fed’s dual mandate to balance employment and inflation, the debate’s understandable—while unemployment has remained stubbornly high, inflation’s been fairly tame (so far), with little to suggest that changes in the very near term.

As we’ve said, QE2 was of dubious necessity when the Fed announced it in November 2010. Consider: GDP had already grown for five consecutive quarters when QE2 was announced, and the private sector added jobs throughout 2010. Economic recovery typically leads unemployment improvement—so while it’s improved slower than some would like, the lag’s hardly unexpected. Also, one of the main effects of quantitative easing is to boost bank reserves. But the financial sector already had over $1 trillion in excess reserves as of QE2’s launch—meaning that wasn’t much of a pressing issue.

Still, there wasn’t much immediate harm done—since QE2’s launch, the economy’s continued growing and corporate profits have been strong. The drawback, as we’ve pointed out, is QE2 could complicate the exit strategy from accommodative policy—and debate is already underway on just that. Depending on one’s view of extant economic conditions, most fall into one of three camps:

• End it early(those who believe continued pump-priming likely sparks near-term inflation given current economic growth).
• Continue until its originally planned expiration in June (those who believe the economy’s improved, though still on shaky ground).
• Roll right along with QE3(those who argue employment, housing, or [enter your currently lagging data point here] are still significant drags).

The debate’s far from over and likely rages until QE2’s expiration in June—in fact, it’s probably just beginning. And between now and then, many things could happen to tip the balance one direction or the other or shift the focus altogether. We’ll abstain from speculating on the Fed’s short-term decision-making regarding QE2 in coming months. After all, the Fed isn’t a gameable free-market function—it’s a monopolized function, as is central banking in all countries. But considering the possibilities above, an early end to QE2 likely wouldn’t be a bad thing (the economy was growing just fine before it and just fine after), and continuing as expected certainly wouldn’t surprise markets. As for QE3, that seems highly unlikely (and unnecessary) as of now. And, lacking a counterfactual, it’s going to be awfully hard to judge QE2’s success, failure, or even ineffectualness prior to unwinding it (which is where QE2’s rubber meets the road).

Generally speaking, all the debate regarding QE2 is one more factor contributing to a back-and-forth year for stocks. Considering its heated nature, the debate’s sort of a mini-illustrationof the bullish and bearish camps today. But it’s likely not strong enough on its own to derail continued economic growth in 2011. Quantitative easing—or the lack thereof—is not now and never has been the single factor determining whether we have growth or not. (Come to think of it, no such single factor exists that we’re aware of.) Keep in mind too that monetary policy isn’t a sports car—it’s pretty lumbering. This isn’t to say the Fed hasn’t radically overshot in the past (it has) and can’t again—but major fallout from future monetary policy typically takes some time to be felt.