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Why Do We Need QE 2 If QE 1 Worked So Darn Well?

By Nico Isaac
Thu, 04 Nov 2010 18:45:00 ET
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If you happened to be walking down Wall Street on Thursday, November 4, chances are you didn't get very far before hearing some cheery pedestrian shout out, "Happy QE2 Day!" The unofficial (yet widely observed) holiday was coined in honor of the Federal Reserve's second round of "quantitative easing," the time-released plan to buy $600 billion  of US Treasury securities over the next seven months.
A triple-digit rally in the Dow seemed to pacify any doubts about the merits of the Fed's move, as these news headlines suggest:
  • "QE2, A Thrill Ride For Stocks So Far"
  • "QE2 Sets Sail, Stocks Cheer"
  • "QE2 To The Rescue"
I just have one nettling question: If quantitative easing is such a "Q"uick "E"lixir for economic weakness, if it's able to leap tall bond markets in a single bound, then why did the first round of buybacks fail to jumpstart limping growth?
As for the extent of QE1's impotence, the October 2010 Elliott Wave Financial Forecast has this stop-what-your-doing-right-now-worthy detail:
"The depth of QE1's failure is visible in the difference between the original amount of quantitative easing and the credit growth it was supposed to generate. From September 2008, when the quantitative easing actually started, to June 2010 a $2.46 trillion ($1.43 trillion in assets and $1.03 trillion in excess reserves) increase in the Fed's balance sheet coincided with a decline of $296 billion in total US credit market debt outstanding. Consider also that up until 2008, the total credit market debt rose for 63 consecutive years."
The bond buying "bazooka" of $2 trillion in two years failed to loosen the public's purse strings. By comparison, QE2 is a BB gun, shooting one-third the amount in one-third the time.
Then there's the other glaring problem: namely, the more debt that the Fed takes over from institutions that can no longer carry their post-2007 toxic debt, the less valuable the central bank's portfolio becomes. In his August 2008 Elliott Wave Theorist, EWI President Bob Prechter shed light on this very "Catch 22": (The latest Theorist is part of a risk-free Financial Forecast Service subscription)
"The Fed has $912 billion worth of assets. A year ago, most of its assets were Treasury bonds. In the past year, it has swapped more than half of its formerly pristine portfolio for mortgages and other bank debt. Before August ends, the Fed's ratio of Treasury holdings will fall below 50% for the first time ever. This will mean that the Federal Reserve is no longer the 'federal' reserve."
Bottom line: the QE crusade will give the Fed little more than borrowed time, in the hope that consumers regain their love for credit. Yet the more time that goes by, the more the plan backfires on the central bank's own purchasing power.
QE1. QE2. It doesn't matter. The Fed is up against a force beyond its control: Social mood. The trend in mass psychology has shifted from consumption to conservation. Only when that reverses course will sustainable growth follow.

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