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Market watchers are all waiting to hear whether the U.S. Federal Reserve will announce a third round of quantitative easing at the conclusion of its two-day meeting today. The prospect of QE3 has brought the new "sound money" group out in full force. Given that the U.S. economy continues to stumble along despite two previous rounds of quantitative easing, perhaps it is unsurprising that many people distrust the Fed's quantitative easing program. That said, I do not think the factual record supports the sound money perspective.

There appear to be two general lines of argument made by proponents of sound money/opponents of Federal Reserve (and ECB) policy. The first is that further quantitative easing is destined to cause severe inflation: even hyperinflation. The second argument is that QE3, by increasing the money supply, will drive commodity prices up. This, in turn, acts as a hidden tax on consumers, and thus QE3 would hurt the economy on a net basis. However, neither of these arguments stands up to scrutiny.

The hyperinflation argument is found in a recent article called "Why QE3 Will Not Happen" posted here (it's the second one in this thread). The author asserts that a further round of quantitative easing will drive prices up universally, eventually leading to unstoppable hyperinflation. Ultimately, the author compares the U.S. position today to Weimar Germany back in the 1920s. However, this entire line of reasoning is built on a lack of understanding of what really drives inflation (particularly hyperinflation).

To put matters in the simplest form possible, severe inflation is the result of a money supply that is increasing much faster than the supply of assets. Essentially, too much money is chasing each asset, creating a bidding war of sorts, and driving prices higher. In the case of Weimar Germany, the hyperinflation of 1923 occurred primarily because the German government paid hundreds of thousands of workers to strike against France's occupation of the Ruhr district. Thus, the market was flooded with currency even as output was artificially choked off. With lots of money but very little available to buy, hyperinflation took off.

By contrast, there is no good reason to believe that easing the money supply today will spark rapid inflation. In addition to having official unemployment of over 8%, the U.S. has a massive stock of underemployed workers. The same is true in most other major economies. There is thus a huge amount of human capital (i.e. assets) sitting unused or underutilized today. So while adding to the money supply may have modest effects on prices throughout the economy, it will not create the "bidding war" that constitutes severe inflation. The current unemployment and underemployment rate implies that the U.S. could produce a lot more with its current asset base, if demand warranted.

The second argument is found in an article by Robert Lenzner at Forbes. Lenzner makes the following extraordinary claim: "rising oil prices due to QE1 and QE2 act like rising interest rates--and stall the economy into recession." He asserts that QE3 (if implemented) will have the same effect, thus hurting the U.S. economy. In response, it is first important to note that one of Lenzner's key contentions, "During QE1 in 2008 the price of crude oil soared to over $140 a barrel," is simply false. While QE1 began in 2008, it began in December 2008. In other words, oil's spike above $140 happened with no assistance from quantitative easing. By contrast, the subsequent fall below $50 came at the same time as QE1 was occurring.

This should not really be that surprising. During late 2008, the global economy was in turmoil and demand for oil was low. Thus, even with the Fed pumping lots of money into the economy, oil prices fell. By contrast, earlier in 2008, many people thought that $100 oil might be compatible with continued economic growth. With higher expected demand at that time, the price rose. In other words, fundamentals are ultimately the key to commodity prices (and stock prices). The herd effect of the market may give monetary policy some effect on short-term pricing, but ultimately supply and demand keep prices in check.

It may seem natural to conclude that "easy money" causes commodity price spikes when you look at the five-year chart for oil (specifically, Brent crude).

click to enlarge images

(Courtesy of YCharts)

Prices have been on an uptrend ever since bottoming out in late 2008, around the same time that the first round of quantitative easing began. The chart thus suggests a direct correlation between the rising money supply and commodity prices. But what if you look at this chart instead?

(Courtesy of InfoMine)

Somehow an inflated money supply did not manage to prevent a collapse in natural gas prices which began in 2008 but has continued to date. This is all the more odd for believers in the "commodity price spike" argument, because whereas oil is globally traded, U.S. natural gas cannot be effectively shipped outside North America. (Therefore U.S. natural gas prices should be more closely tied to the U.S. money supply.) If the money supply were really the primary determinant of prices, rather than the fundamentals of individual markets, natural gas prices would be five or ten times their current level.

As it turns out, the fundamentals of the oil market look pretty bearish today. The "hard landing" in China has removed that country as a major source of oil demand growth. Meanwhile, U.S. petroleum product imports have reliably been declining year over year. Indeed, with the busy summer travel season having just ended, oil demand is likely to tail off dramatically, even while U.S. crude oil stocks remain "above the upper limit of the average range for this time of year." Obviously, a flare-up in the Middle East could quickly change the supply picture, but barring that, oil prices look to have downside of 20% or more this fall.

To conclude, in the short run, QE3 might give a little boost to asset prices, such as S&P 500 (Pending:GSPC) stocks and commodities. I'm sure owners of stocks will not complain about that. On the other hand, arguments about the dramatic and dire effects of QE3 on inflation and commodity prices are nothing more than hot air. At worst, QE3 will have minimal effect; at best, it might keep the economy from falling back into recession.

Source: Why I'm Not Afraid Of QE3