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On August 27, 2010 the U.S. Federal Reserve made it apparent that an asset purchasing program known as quantitative easing, or QE2, would be implemented. This program featured a plan to purchase $600 billion of long dated U.S. Treasuries from November 2010 to June 2011.

Reactions to this announcement varied around the globe. U.S. equity holders rejoiced while foreign central banks, particularly in emerging markets, cried foul, stating that the unintended consequences would result in a flood of demand for their currencies as investors searched outside the U.S. for yield. Some critics alleged the United States was intentionally trying to devalue their currency in a desperate attempt to export its way to economic growth. Ben Bernanke countered by stating in a Washington Post op-ed piece that the desired outcome was to create easier financial conditions that would promote economic growth. The program was supposed to spark increased risk taking behavior by investors while also pressuring borrowing rates for both corporations and the general public lower.

After investors started shifting their dollars out of U.S. debt and into higher risk securities such as equities and commodities, the belief was that wealth would be created from higher asset values. The theory further stated that this increased wealth would boost confidence among consumers, who would feel more comfortable spending and U.S. economic growth would therefore accelerate -- all while the employment situation improved. Now that we are weeks away from the end of this experiment, it may be worth asking the following questions: Did QE2 have an impact on investor behavior and the economy during the last nine months? What can we expect when QE2 concludes?

From the unofficial announcement on Aug. 27, 2010 to the close of markets on May 27, 2011, the S&P 500 index appreciated over 27%, not including dividends. Commodities witnessed a wide range of gains, including crude oil gaining 37%, gold rising 24%, and both corn and silver increasing 94%. The U.S. dollar, meanwhile, depreciated approximately 10-15% against a basket of other major currencies according to the performance of several different ETFs which track this particular movement. Treasuries have had a wild ride with the yield on 10-year note increasing to 3.74% in early February from 2.48% the day of the announcement, before backing down to just above 3% as of late. Although treasury rates have increased, mortgage rates decreased significantly from 5.4% in August 2010 to 4.8% now.

While these statistics seem like great news, we must look deeper before declaring QE2 a success, or that these movements are correlated at all with QE2. Investors did in fact shift money away from U.S. treasuries and into riskier assets such as equities and commodities, and borrowing rates for consumers, especially mortgage rates, decreased. However, this didn’t result in increased home-buying activity. Despite a massive flood of home refinancing in early 2011, the U.S. housing market remains weak. Consumer sentiment and spending rebounded nicely from August to March, but in recent weeks these numbers have been weak. Consumer spending was up only 0.4% in April, all while the personal savings rate dropped to 4.9%, the lowest percentage since October 2008.

Economists have also recently downgraded their estimates for this year’s GDP to below 3% growth as the economy grew only 1.8% in the first quarter of 2011. The headline unemployment rate has declined from 9.7% in August 2010 to 9.0% in April 2011. However, it’s difficult to make the case that the employment scenario is very healthy, given lower labor force participation and a still high under-employment rate of 16%, which records the percentage of those both out of work and those who are working part-time jobs that desire a full-time job.

Corporate profits have remained strong, but many of the companies showing true revenue growth are doing so because they generate revenues from international economies, sell discretionary goods to high-end consumers, or have large exposure to commodities. More traditional retail outlets such as Wal-Mart (WMT), which have historically been a better gauge of U.S. consumer behavior, reported that same-store sales dropped 1.1% in Q1 of 2011, which was the eighth consecutive quarterly decline. Consumers and corporations alike are citing high commodity costs as hampering both discretionary spending and earnings growth.

Clearly the U.S. economy is not performing extraordinarily well, but this isn’t necessarily shocking news. Many U.S. corporations domiciled domestically have known that growth would be much stronger in developing economies such as China, India and Brazil, and have shifted their businesses in order to diversify and decrease their reliance on the U.S. economy. Over the last several years, the entire world has relied heavily on economic growth in emerging markets as developed markets remain sluggish, so perhaps we should more closely examine the effects of QE2 on the economies of developing nations.

As it turns out, foreign governments and banks may have had reason to grumble after the initial announcement of QE2, considering many of the fastest growing economies have been raising interest rates and reserve requirements at financial institutions in response to both higher demands for their currency and commodity prices, which is creating inflation. Specifically, China reported that annual inflation registered at 5.6% last month, which is mainly attributable to an 11.5% increase in food prices, the sixth consecutive double-digit increase. While GDP in China has been relatively strong when compared to developed markets, estimates for future growth have been trending down into the high single digits.

Of course another possibility is that QE2 hasn’t had much effect on the worldwide economy, and these results are purely coincidental. Generally economic data and corporate profits drive the prices of securities, not the other way around. Also, assuming there must be some sort of lag involved between the allocation of securities purchases by the Federal Reserve and the subsequent effects on the economy, it’s hard to believe that we have even seen the final outcome of QE2. After all, the $600 billion program wasn’t nearly as large as the $1.75 trillion worth or securities purchased by the Federal Reserve during the first round of quantitative easing that took place from early 2009 to early 2010.

The best case scenario is that the U.S. economy is now capable of standing on its own feet and we are on the gradual path to full recovery. Under this scenario, QE2 will be put aside and natural market forces will once again solely dictate the prices of securities. The decision to not extend quantitative easing should be interpreted as either a signal of confidence from the Federal Reserve that the U.S. economy has reached a point of stability that no longer requires the purchases, or that the program wasn’t creating the outcome that the Federal Reserve initially desired and therefore has no reason to remain active.

However, should U.S. economic growth and asset valuations begin to decline considerably in the upcoming months, there does appear to be an expectation among investors that the Federal Reserve would step in once again with a third round of quantitative easing. While the immediate impact would likely yet again be higher asset values in the short run, this would be a troubling sign for the overall health of the economy, and should clearly indicate the program is at best a minimal short term aid, and at worst a failure.

Source: QE2 Party Is Over - What Now?