Forget Cash-For-Clunkers, QE2 Is Cash-For-Spelunkers

Like “cash for clunkers,” the housing tax credit and other attempts to provide short-term fuel, the Federal Reserve’s second round of quantitative easing can only buy a little time to fix what ails the economy.

Unfortunately, in the prior instances, the short-term fuel led to short-term complacency about the economic trajectory, leading policymakers to let down their guard. In the end, all that resulted was a letdown for the economy.

What’s different about quantitative easing — an effort to lower market interest rates by bidding up Treasury debt — is that the Fed has no ability to direct its fire. What’s likely is that much of the investment capital freed up by Fed purchases of Treasury debt will overshoot its target — the U.S. economy — and flow to emerging markets and especially into commodities that serve as a hedge against a falling dollar.

Hence the “cash for spelunkers” label: The only thing certain to be stimulated by quantitative easing is mining and, perhaps, other underground exploration. Already precious metals have seen a big run-up in prices in advance of further Fed easing, as have industrial metals, crude oil and agricultural inputs — anything that can hold value as the Fed prints money.

The downside is that the squeeze from higher commodities prices, both on businesses facing higher input prices and households seeing little income growth, is likely to dampen the positive impact of quantitative easing.

And if the net impact is quite small, then the Fed’s success in inflating asset prices will prove fleeting.

The reason that the Fed is expected to move aggressively is because Congress is letting its stimulus spending gradually begin to wind down, even as the economy grows too slowly to keep the jobless rate from rising further.

But the Fed’s ability to move independently from the political sphere, even when there’s gridlock in Congress, is a mixed blessing. The risk is that Fed intervention will take pressure off of the incoming divided Congress to reach difficult agreements that will address some of the underlying ills that could sap the recovery.

Not least, of course, is the need to agree on a difficult but carefully mapped out path back to fiscal sustainability as the recovery strengthens. Without such a path, Fed money printing could undermine confidence in the dollar and Congress may hit the fiscal brakes too abruptly.

It’s no coincidence that the economy began to slow in the spring as the Fed ended its first round of asset purchases and federal stimulus hit a peak from which it began to descend. Hopefully we are not headed for an eventual second round of QE-letdown.

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