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Although the consensus agrees that Quantitative Easing (QE2) is merely a matter of degree, I disagree and see it only as an effort to remain relevant after two years in a zero-rate world. It's a bluff and will not be done in any meaningful way. Even though the Fed blusters like the Mighty Wizard of Oz, it understands the terra incognita upon which it now treads.

QE1 was essential to stem the deflationary spiral about to wrap up into an unstoppable vortex. It mattered not what the programs were called as long as they "judiciously" reflated the falling assets - and they did so magnificently. We were indeed on the precipice and they pulled us back. We are now far, far from that abyss and launching the QE2 would potentially unleash a malevolent Genie ostensibly aimed to combat a phantom menace. The threat of deflation has passed. Risking the unintended consequence of Stagflation or Hyperinflation is simply not warranted at this stage of the recovery.

Buying longer-term Treasuries will do nothing to stimulate growth and threatens to recreate the Stagflation of the early 70's. The cost of money is not holding back its velocity. As a small business owner, I would love a vault full of this cheap money but it's not available to me. A major bank quotes me a fixed 5-year loan for 6.5% when the equivalent Treasury's yielding a bit over 1%! Banks can buy money for next to nothing, are enjoying tremendous markups but still have little interest in making loans. This begs the question of why they are not in the business of lending, to very credit-worthy businesses, other than at loan shark rates?

Why take the risk when you can make "free money"? Banks can funnel their deposits to Treasuries and make a handsome profit. An uglier way to look at is that, through extending federally-controlled low rates, banks are essentially being nationalized while still remaining private. The government insures the low-cost of deposits and also the guaranteed profit. Nationalizing private banks, without consuming their public shares, dooms not only this recovery, but capitalism itself - if not halted soon. Banks must be weaned off their government-subsidized existence by cutting off their free money.

Functional American capitalism deftly dances between the extremes of deflation - that deadliest of conditions, and inflation - the necessary evil of stability. The Federal Reserve has made great progress in creating inflation to promote price & employment stability since its inception in 1913. That has largely been done through interest rate cuts and monetary injections. In the wake of the housing bubble's deflation (Modern Depression) we are in a new and unknown chapter of economic history. The headline battle continues to convince many that the recovery is not genuine, to the point of forcing the hand of the Feds - or is it?

I believe the Federal Reserve knows the potential (unintended) damage if the Genie of high inflation is loosed into an already stagnant environment. That is an ugly conundrum known as Stagflation. Further, when and if banks are forced to go back to the business of making loans, the growth will demand an aggressive rise in the Federal Funds rate. That will flatten the yield curve, crimp bank profit and threaten another recession. These conclusions are not rocket science.

The good news is that I believe Big Ben knows this better than I do. "Moral suasion", a tool once reserved for member banks, is now being directed to a public audience. Ben originally sought to distance himself from the obfuscating Greeenspeak of his predecessor, but the uniqueness of the situation has apparently modified that. Bernanke has already begun the process of equivocation in his appearance last Friday. While reiterating the efficacy of this nuclear measure known as QE2, he also alluded to the potential for unintended consequences of such action. In other words, he created an escape clause. As the numbers confirm the recovery, the purchases will diminish. They will simply make the case that it isn't necessary. Goal achieved.

A swift kick - After years of expecting my dog to come home with a mortgage tucked into his collar, I now struggle for no tangible reason, to refinance my home. The programs enacted by the Feds (QE1) staunched the deflationary bleeding but the peculiar and dysfunctional banking system born of that intervention has too little incentive to allow growth to resume. The banking system needs a swift kick in the pants through raising the Discount /Federal Funds rate. The Federal Reserve, ostensibly the adult in the playground, needs to remind the banks that they are private institutions in the business of lending money - and not just to the largest companies. The best way to accomplish that is to raise the discount rate. Doing so will also serve to reestablish a functional yield curve and subsequent organic growth cycle.

We are recovering, albeit by scrabbling up a wall of terror this time. Controlling both ends of the yield curve (QE2) is inappropriate and far too dangerous for an economy clearly recovering, even if from a Modern Depression. Although the Fed will buy a bit of bonds to make good on their stated policy it will not keep interest rates down. Interest rates will rise and that is a very good thing for both the economy and its barometer, the market.

PS - An unpleasant thought: If Bernanke is indeed disingenuous in his threat to buy longer-term bonds, one might view the ploy as a nefarious tool. With interest rates at historic lows, and the lure of free money from "front running" the Fed, the government will gets lots of eager buyers to finance thier debt at the lows. Good for us collectively, yes, but then you'd have to wonder about the veracity of every institution.

Disclosure: Leveraged buyer of US equities, leveraged seller of Japanese equities, leveraged seller of bonds.

Source: Big Ben's Brilliant Bluff: To QE or Not to QE?