QE2 Creating Unintended Consequences

The impact of the latest round of quantitative easing by the Federal Reserve is already having unintended consequences. Going back to last Friday 5^th November, we saw the Labor Department publish better than expected non-farm payroll figures *1, this led a spike in the dollar, which consequently led to a decline in equity prices.  The same happened again this week on the 10^th November when better than expected employment figures *2 were released. The dollar reacted positively to this news, where as the equity market went in the other direction.  This is the effect of QE2, better than expected economic data is greeted with a decline in equity markets due to fact investors fear that this will limit how much quantitative easing will be used. Worse than expected economic data leads to a rise in equity markets due to investors believing the economy is recovering less quickly than expected thus the Federal Reserve will plough more money into the economy through the process of QE i.e. buying a range of treasuries with varying maturities.

Notice the month of November towards the far right of the chart showing a gradual rise in the US Dollar Index and compare it with the chart below showing a steady decline in the S&P 500 - the benchmark US equity market. 

 

This reasoning behind the Federal Reserve use of QE is because it pushes longer term interests down still further, thus pushing investors towards higher yielding asset classes i.e. the equity market (stocks) commodities (gold & silver been the prime targets).

However perhaps the most worrying consequence of Quantitative Easing is that it inflates commodity prices to extreme levels. Commodities such as Sugar, Cotton, Corn and Coffee have soared to new highs since the Federal Reserve hinted it would use further measures to sure up the economy during the Jackson Hole summit back in late August. This has consequences for the consumer who will be forced to pay higher prices at the checkout as a result of soaring commodity prices since companies will have to push the costs onto the consumer. As a result this will have a negative impact on the general population of the US, more specifically the poor whom it will effect the most. ( see charts - http://www.finviz.com/futures_charts.ashx?t=SOFTS&p=d1 & http://www.finviz.com/futures_charts.ashx?t=GRAINS&p=d1 )

In some cases companies such as Walmart in the US and Tesco in UK will be able to absorb these prices, due to the pricing power these giant retailers have, thus limiting the extent to which they have to hike up prices.

In summary if companies begin to push prices onto the consumer this will undermine consumer confidence which could undermine consumer confidence, already dented as a result of the financial crisis and make them think twice about purchasing certain goods that they would have otherwise have done. This could potentially have damaging consequences to US economic growth, due to the size of the consumer base in the US which equates for approximately 70% of the overall economy.

*1/ Increased by 151,000 compared to analysts expectations of a rise of just 60,000.

*2/ Initial Claims 435,000 compared to analysts expectations of 450,000 & Continuing Claims of 4.301 million compared to estimates of 4.350 million.

For a visual explanation of QE courtesy of the FT  Quantitative Easing Explained (FT Video )