10/18/2010 06:05 pm ET Updated May 25, 2011

The Joys and Horrors Of QE2

In football, they call it a Hail Mary Pass -- a last-minute act of desperation in which a quarterback throws a very long forward pass which has only a minimal chance of success.

That's essentially how economist Madeline Schnapp of West Coast liquidity tracker TrimTabs Research, partially owned by Goldman Sachs, views the widely expected second round of quantitative easing, or, as it's called, QE2.

What excites so many people is that QE2 is supposed to be a significant economic booster. In brief, the Federal Reserve prints money, which is used to buy long-term debt from banks that gives them more capital to lend and lower interest rates. In turn, that injection of this liquidity supposedly will goose the economy, stimulating more job creations, more housing sales and higher wages and salaries.

The QE2 program -- estimated at between $500 billion $1 trillion -- is expected to be announced November 3 at the Fed's Federal Open Market Committee meeting.

The first such easing, QE1, an estimated $1.5 trillion, took place in March of last year. As you can tell by the ongoing sluggishness of the economy, it has hardly been a bell-ringer.

Still, Wall Street, despite the failure of the initial easing, is gung-ho on QE2 as an economic panacea, evidenced by the fact that it recently embarked on an aggressive buying spree, driving up the Dow from 10,000 at the end of August to above 11,140.

Schnapp, dubbed by some as Lady Dracula for her generally grim economic outlook, surprisingly had some cheery things to say about QE2, but she hedged them with a big IF.

She believes that "if QE2 turns out to be successful, then we are already at a bottom." Assuming this is the case, she sees some noteworthy advances on the economic front between now and the end of 2011. Chief among them:

  • A rise in the GDP nominal growth rate (adjusted for inflation) from 1.5% to 3%.
  • A drop in the unemployment rate from 9.6% to 8%, or from about 15 million jobless workers to 12 million.
  • Growth in consumption from 2.7% to 3.9%.
  • A rise in the annual rate of new and existing home sales from 4.7 million to 5.5 million.
  • A decline in housing inventories from 11.4 months worth to 8.5 months.
  • A drop in mortgage delinquencies from seven million to six million.
  • A decrease in foreclosures from 1.5 million to 800,000.

"Obviously, if the government throws enough money at the economy to drive down interest rates, there are bound to be benefits," observes Schnapp. "I'm not jumping up and down, but near term it will bring about some modicum of growth as the government chooses pleasure over pain."

But longer term, she hastens to add, "this is a pact with the devil and we could end up in tears."

Her big concern, she says, is the Fed is now traveling in uncharted waters and there are huge risks of serious unintended consequences that may blunt or reverse near-term gains.

In essence, she notes, the Fed is shifting its focus from its legislative dual mandate of maximum employment and price stability to specific inflation targeting. In particular, she takes note of wage inflation (in which demand for goods and services exceeds available supply, driving up wages), and she expresses fear the Fed's actions may stimulate other types of inflation, as well, which could extract a cruel price on pensioners and savers.

Interestingly, while many economic pundits debate the prospects of both inflation and deflation, Schnapp warns that QE could, in effect, lay the groundwork for out-of-control inflation, triggering sharply higher prices for oil, food and raw materials, which, she notes, could force the Fed to raise interest rates in a weak economy.

Taking note of the rising costs of such commodities as oil, cotton, gold, silver, copper and coffee, Schnapp says higher prices are already here and she thinks we could be looking down the pike at an inflation rate of 4% to 5%, versus a current level of just above 1%. And this kind of a spike, she notes, could force us into another recession, as was the case in the early 1980s.

Given the risks, Schnapp says, "QE2 seems like an act of faith. The Federal Reserve is praying for the monetary equivalent of an afterlife."

My thought about all of this: Based on the books and stories I've read and the movies I've seen, pacts with the devil always turn out to be a hellish experience.

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