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Stocks have moved dramatically on the "bad is good" theory of investing in recent weeks. That theory states that more bad news will motivate the Federal Reserve to go to QE3 and inflation will be the result, driving equities and other assets higher. The flaw in that thinking is that investors simply don't understand what QE actually does and why additional QE will not have any impact.

To assume that QE3 will work to expand money supply and regenerate inflation is a flawed assumption. Investors who are basing their investment decisions on QE3 are going to be disappointed. A little refresher course on Money and Banking should help to shed some light on the matter.

The fractional banking system and QE impact on money supply:

Let's consider the Federal Reserve's purpose for initiating QE. The goal is to inject liquidity into the fractional banking system so that banks can increase lending and in so doing expand money supply. It is a misnomer to assume that the Federal Reserve can create money out of thin air as some apparently believe. What they can do is set the stage for the fractional banking system to print money.

Keynes tells us what we need to do to stimulate economic growth when we are in a recession or a depression:

" ... if Investment exceeds Saving, there will be inflation. If Saving exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving. This runs contrary to the prevailing wisdom, which says that thrift is required in hard times. In Keynes's words, 'For the engine which drives Enterprise is not Thrift, but Profit."

The table below is revealing in that it establishes that we have done the exact opposite of what Keynes says is necessary for a recovery. What we have done since the start of the Federal Reserve's QE programs is increase savings.

Impact of QE1 and QE2 on Money Supply(trillions)

ActionM2SavingsM2 - Savings
QE1 start- Nov, 20087.9954.0323.963
QE1 end - Mar, 20108.5024.9633.539
QE2 start - Nov, 20108.7475.2973.450
QE2 end - June, 20119.1655.7173.448
June, 20129.9266.3373.589

The table above shows a modest expansion in M2 during the QE years from $7.995 trillion to $9.926 trillion - an increase of 24% over the period which works out to be an annualized rate of increase of 7.7%.

By contrast, the two year period of time just prior to initiating QE1 resulted in annual increase of 6.7%. Considering the magnitude of the Fed action to inject liquidity into the banking system, an 1.1% increase in the rate of growth of M2 is insignificant.

The next number to look at is the savings portion of M2. Savings is broken out as a separate line item of the total M2 figure. According to Keynesian theory, we want savings in dollar amounts to decrease, remain flat or at least expand at a slower rate than the broader M2 number.

Here's why we want and need savings to remain at low levels. As Keynes points out, conventional wisdom suggests that you should save during times of uncertainty and economic contraction but that is the exact opposite of what we should do. From an individual perspective, this might be a wise decision but for the broader population to engage in a policy of paying off debts and saving virtually insures a continuation of the recession.

It's a rather circular process that is either working in the right direction or the wrong direction from a macro point of view. If we begin to spend at an increasing rate, the effect is an increase in the demand for goods and services. As demand increases more workers are needed. As those workers are hired, the unemployment number shrinks and more workers, now with paychecks, enter the consumer pool and begin to spend. That increases demand further requiring additional hiring to meet the demand. As the process continues, we eventually reach full employment.

The counter view is that we reduce spending, which reduces demand, which results in layoffs, which reduces the consumer pool, which reduces spending further resulting in further demand reduction and more layoffs. The result is an increasing rate of unemployment and shrinking demand, which impacts corporate profits.

The table above shows that we as a population have not reacted as we should to stimulate growth. Instead, we have taking what Keynes refers to as the "prevailing wisdom" path. We have paid down debt and increased savings. The reaction is a natural one in that we don't know when we might get a pink slip ourselves - best to prepare for it is the logic.

Savings have grown from $4.032 trillion to $6.377 trillion during the QE period - an increase of 57% versus the M2 growth increase of 24%. Savings has increased at a rate of 2.4 times the rate of increase in M2.

The last set of numbers above shows the real impact of QE - it shows the direction that spendable money has taken. To arrive at that number we subtracted the Savings portion of M2 from M2. The result is the amount of money we presume to be available for spending. Remember, as spending shrinks the economy contracts and unemployment moves higher.

The M2 less Savings number started out at the beginning of QE at $3.963 and ended at $3.589 on June 30, 2012. That is a reduction in real spendable dollars of 9.5% over the period. What we can take away from this is that the problems we are facing in our attempts to recover are in fact of our own making.

The Federal Reserve has gotten a bum rap from politicians and the public. They have done their job, which is to set the stage for a recovery. The Fed didn't create the problem in the first place but they did step in and did what they could within the scope of their powers to set the stage for a recovery. The fact that banks, politicians and U.S. citizens didn't cooperate is simply not the Fed's fault.

So what has the Fed done? The Fed has reduced interest rates all along the yield curve with rate cuts and Twist operations. Additionally they have flooded the banking system with cash. Let's take a look at how the fractional banking system really works.

The Federal Reserve operates as a guidance system for the economy by expanding or contracting money within the economy. They do that by increasing or decreasing cash reserves within the banking system.

The nation's banks must maintain a cash balance equal to 10% of liabilities, which means that they can't make loans when that cash position drops below the reserve threshold. When banks make loans, they are effectively adding cash into the economy. When loans are paid off they are effectively reducing cash in the economy.

When the Fed wants to expand money supply, it injects cash into the system by buying Treasuries that the banks own. The balance sheet impact is a reduction in Treasuries and an increase in cash on the banks' books and the exact opposite effect on the Fed's books.

Now the banks can increase the dollar amount of loans. So what has happened since QE1 and QE2? What we have done is nothing. The banks have been reluctant to loan and borrowers have been reluctant to borrow. Both groups have valid reasons for taking these positions but the impact is that we have fallen into a period of stagnation as a result and it is entirely possible that this deleveraging process coupled with self imposed austerity will continue. If that is the case, we can expect continued high employment and shrinking corporate profits.

The Feds frustration and what they will do this week

As we prepare for the announcement of additional stimulus, the Fed must be frustrated. Additional QE can accomplish nothing at this point. Here is why: All QE can do is inject additional cash into the banking system. It can't force the banks to lend it out nor can it force borrowers to borrow it.

The banking system is flooded to overflow with liquidity that is not being utilized. Further increases in that liquidity will not change a thing at this point. It would be like adding water to a glass that is already full to the brim. Adding water to the glass till it overflows will not make you drink if you are not thirsty.

The Fed is stuck in a situation where the only tool they have at their disposal is rhetoric. Actual QE is useless but since the public and in particular investors don't understand how the process works they still have the hope that the public will respond to the promise that the "Fed has their back."

Expect more of the same from the Fed this week. There will be no QE - that would be bordering on irresponsibility. There may be an extension or modification of Twist, which is designed to keep interest rates low along the yield curve. Of course, rates are already low and no one's borrowing, so that is not likely to have much impact.

As Bernanke told all those who actually paid attention in his recent Jackson Hole speech, Fed policy going forward is very limited in what it can accomplish:

"Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain and the use of nontraditional policies involves costs beyond those generally associated with non-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally. Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly can't fine tune economic outcomes." Bernanke speech at Jackson Hole, August 31, 2012

Understanding "Fed speak" is not particularly easy if you don't understand the fundamental concepts of monetary policy. Hopefully after working your way through this brief explanation you now have a better understanding of how all this works. If not, I will try to translate.

What Bernanke is saying is we have done all we can do. We have flooded the banks with liquidity and flattened the yield curve like a pancake. It is now up to Congress, the president, the banks and the people to do their part.

Notwithstanding that position, the Fed will use what they refer to as "education and forward guidance" to keep our hopes alive. What we can expect from the Fed is a continuation of the current Twist program with some minor changes - probably a more open ended version of the current program. All that will do is keep interest rates down though. It won't force banks to lend or borrowers to borrow.

The Fed has primed the pump. There are massive amounts of liquidity in the banking system and large cash balances in the banks. The Fed can do no more.

Bernanke will conclude with his boiler plate remark:

"Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in the labor market conditions in a context of price stability." Bernanke speech at Jackson Hole, August 31, 2012.

Source: Zero Chance For QE3 - The Fed's Job Is Done