Demise of QE2 - What Does it Mean ?

Little Johnny falls off the chair and scrapes his knee. What do you do? Do you run over, scoop him up, and scold the chair? Do you assess the damage out of the side of your eye? Do you ignore his crying and let him gather himself  - hoping that he is learning a lesson from this?

It is very likely you won't always be there to scoop little Johnny up. There comes a time he will have to take care of his own scrapes. There is a point where he will dry his eyes, look around  and realize nobody's coming to his rescue. He's going to have to pick himself up.

The financial markets have a "little johnny  problem' of their own right now, albeit probably temporarily. On June 30 the program known as "Quantitative Easing 2 " (QE2) is scheduled to end. This program supports markets by buying large amounts of Treasury securities. It was initiated in March 2009 and is generally credited for the 90% increase in stock indices since then as well as sharp rises in commodity prices and the weakness in the dollar. Most importantly, it is credited with scooping up a damaged economy, brushing off its shorts, and putting it on an upward course.

Some have used the apt "taking off the training wheels" metaphor. Inevitably when economies are artificially stimulated, there comes that time where the stimulation has to be ratcheted down and eventually ended. Wait too long and we end up like China, where it is pushing interest rates higher and increasing bank reserve requirements to fight off inflation as the world watches nervously.

A subtle problem can arise if it actually works smoothly- the training wheels come off and we go pedaling down the road with a recovering economy and financial markets behaving. Bernanke and cohorts will likely have an ongoing high-fiving party and then, when we hit the next bump, be fast on the draw to pull out the QE tool again. This is what leads to longer-term problems. This is what makes Johnny an adult who needs help blowing his nose. A recent example of this was the so-called "Greenspan put" whereby the former Fed Chairman lowered rates at every sign of an economic slowdown--gaining the title of "The Maestro" in the process. Eventually lower rates became impotent, and they had to be pushed to 1%--resulting in the housing crisis and its aftermath.

An even longer-term manifestation of this was the embracing of deficit financing even when the economy wasn't severely weak. We will be digging out of that one for a while.