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QE (quantitative easing) is essentially the printing of money and the addition of liquidity into the markets so that stock (and other asset) prices are given an artificial boost. Federal Reserve Chief Ben Bernanke believes that by pulling up stocks, the masses will feel richer and spend more on consumer goods, thus lifting up the economy. This is based on Karl Marx's reflexivity theory (George Soros essentially paraphrased Marx) that states by turning the small wheel (stocks), you can turn the big wheel (economy), which in turn will come back and turn up the small wheel (stocks). Bernanke subscribes to such a theory, and he wants QE to lift up the small wheel (stocks), which he hopes will lift up the big wheel (the economy).

But after two successive rounds of QE (QE1 in 2009 and QE2 in 2010), it has become crystal clear that quantitative easing doesn't work nearly as well as theory says it should. In the short term, QE can pull up stocks and the economy, but in the long term the economy is going to go where it's going to go, regardless of how much liquidity the Federal Reserve is pumping into the economy and stocks. Everyone has now recognized that the economy is slowing down (including Congress), and everyone knows that the Federal Reserve has only one bullet left: QE3. QE is like a medicinal drug -- take it once, and you'll heal very quickly. But every time the disease comes back, you'll need to take bigger and bigger doses of the drug, and each time you take it, the drug becomes less and less effective until eventually it's useless. QE3 is the last round of QE because everyone knows that QE4, 5, 6, etc., will be pointless.

The Federal Reserve is holding a meeting from July 31 to Aug. 1. Will QE3 be announced at that meeting? Will the Fed shoot its final bullet? Out of the 11 Federal Reserve officials, 10 have already voted "yes." However, the decision ultimately lies with Bernanke, who has veto power. Right now, the commodity and stock markets are stalling and waiting to see what will happen at the August Fed meeting.

Here's what I think about the chances of QE3 being announced at the August meeting:

Factors Influencing Bernanke's Decision

  1. Romney has stated that if elected president, he will not renew Bernanke's term as Federal Reserve chairman in January 2014. Meanwhile, Obama is a great defender of Bernanke, who will do anything in his power to ensure that Obama wins this year's election. Historically speaking, the stock market has had a great influence on electoral results -- the administrations in power at the time usually win the re-election if stocks do OK during election time, while administrations usually lose if stocks fall during re-election time. This means that Bernanke needs to ensure that stock prices don't fall from now until Nov. 4, 2012.
  2. Everyone, including Bernanke himself, knows that this is the Fed's last bullet. If he initiates QE3, Bernanke has no more weapons in his arsenal should the economy and stocks tank hard.
  3. Everyone is looking to Bernanke now. Congress has already said that the economy is slowing down and that the Fed is the "only game in town." If Bernanke doesn't initiate QE3 now, it will seem as if he's behind the curve, which is bad PR for him.

Why Bernanke Will Initiate QE3 at the August Meeting

  1. Bernanke must prop up stocks from now until the election. In addition, everyone knows that the economy is already slowing down, so Bernanke will look bad (from a PR standpoint) if he's too slow in reacting.
  2. If he's going to initiate QE3, he can't wait until the Sept. 12-13 meeting. Markets usually take two to three months to react to QE, which means that if he initiates QE3 in September, it won't have any positive effect on stocks until the elections are already over. This leaves Bernanke with one choice: announce QE3 on Aug. 1.

Why Bernanke Won't Initiate QE3 at All

  1. Everyone knows that this is Bernanke's last bullet, so once he shoots it all the short sellers might sell on the news. Instead of propping stocks up, QE3 might just cause stocks to tank. Bernanke knows this too, which is why he's hesitant about initiating QE3.
  2. Bernanke's afraid that QE might cause commodity prices to rise, which has happened in the past. That is bad for the economy because the cost of everything goes up. Oil prices are already going up and will rise even more should QE3 be initiated. This will send shock waves through an already frail economy.

Whether Bernanke does or doesn't initiate QE3 is uncertain, and if he does, what the market's reaction will be is even more uncertain. I hate investing in markets like this, when you shouldn't really be doing anything because the decision (QE3) can go either way. You never know -- Bernanke might wake up all happy one day and initiate QE3 or, if he's in a down mood, not initiate QE3 at all.

Source: Will QE3 Be Announced In August?