Wednesday, December 15, 2010

WCAM - QE2: Inflate or Die!

While many argue that quantitative easing can’t go on forever, Fed Chairman Ben Bernanke argues that it can go on as long as it takes, even if it requires further expanding the scale of asset purchases or expanding the menu of assets that it buys. Whether it’s QE2 or QE5, what matters is that the Fed has monetized a significant amount of debt and will continue to do so in order to flood the market with cheap capital. From our perspective, the Fed has done everything but scream from the rooftop that inflation is on its way. Whether or not the consequences will be deafening remains to be seen, but we urge investors to pay attention and be prepared.

Cash and long term bonds are the obvious casualties of inflation, while real estate, commodities and certain stocks will be the ultimate beneficiaries. The Fed’s hope is that inflation will increase meaningfully but not at an uncontrollable rate, and that consumers will experience a “wealth effect” as the value of their assets increase over time. Many argue that such wealth would increase only in nominal terms, but for those who have locked in long term debt at historically low interest rates, the wealth effect will be quite real. In turn, the Fed expects such wealth effects to spark consumer spending and stimulate economic activity that results in more jobs and higher government tax revenues.

Unfortunately, it isn’t that simple. As most baby-boomers vividly remember, the 1970’s and early 1980’s were marked by runaway inflation that was coupled with painfully high interest rates and unemployment. Many predict a similar course in the not too distant future, and we don’t believe the Fed has ruled out this possibility.

Ultimately, we believe the dollar will be inflated regardless of whether Bernanke pushes it to the forefront in the near term. The U.S. government’s mounting debt and deficits are simply unsustainable and eventually it will come time to pay the piper.