Excerpt from the Hussman Funds' Weekly Market Comment (10/18/10):
With continuing weakness in the U.S. job market, Ben Bernanke confirmed last week what investors have been pricing into the markets for months - the Federal Reserve will launch a new program of "quantitative easing" (QE), probably as early as November. Analysts expect that the Fed could purchase $1 trillion or more of U.S. Treasury securities, flooding the financial system with additional bank reserves.
A second round of QE presumably has two operating targets. One is to directly lower long-term interest rates, possibly driving real interest rates to negative levels in hopes of stimulating loan demand and discouraging saving. The other is to directly increase the supply of lendable reserves in the banking system. The hope is that these changes will advance the ultimate objective of increasing U.S. output and employment.
Despite the probable lack of measureable benefits, further QE poses significant risks. It has already triggered a steep decline in the exchange value of the U.S. dollar, and threatens a destabilization of international economic activity, a loss of confidence, and the creation of a "boom-bust" cycle threatening to choke off any economic recovery that does emerge.
With regard to the U.S. dollar, market expectations of QE have provoked a "jump depreciation" of the greenback in recent months, neatly following the mechanism that the late MIT economist Rudiger Dornbusch described as "exchange rate overshooting" (see the August 23 market comment Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar). Specifically, the expectation of a sustained period of lower U.S. interest rates, relative to other countries, requires an abrupt depreciation of the U.S. dollar by an amount large enough to set up expectations of a future appreciation. As a crude example, if the Fed suddenly introduces a policy that is expected to depress U.S. long-term interest rates by 1% for a period of 10 years, an immediate 10% depreciation of the U.S. dollar is required in order to preserve equilibrium in the international capital markets. Following the depreciation, international investors expect a 1% annual appreciation in the dollar to compensate for the 1% loss of interest. The plunging U.S. dollar and soaring price of gold in recent weeks are reflections of this dynamic.