What to do About QE 2?

While may are focusing on the elections today, this week’s real event for investors to hone in on comes tomorrow.  For the most part, I think the talk about the elections being “priced into” the stock market totally discredits the real underlying catalysts behind the powerful rally that we have seen since the 1st of September.  The real catalysts being the fact that we avoided a double-dip recession (from late April through early July we dropped in fear of a double-dip recession), the start of the reallocation of capital from bonds to equities and the Federal Reserve Bank’s discussion about QE 2.

In my grand return to the blogosphere following my time away, I wrote down the following thoughts about QE 2,0 that deserve some elaboration:

In my reflective time, I have concluded that rather than seeing the Fed’s statement as an openness to QE 2.0 we should all interpret the message from Bernanke as a “soft” inflation target.  As investors, we should think about it thusly: in the event that inflation remains below the targeted 2% level, the Fed will continue to pursue aggressive monetary policy.  Much like the “extended period” line that continues to reappear, we have yet another example of the Bernanke Fed conducting policy via language.

In the very same post I did posit the idea that the Fed would merely do nothing and use the threat of QE as a means through which to shape market expectations.  While it now is clear that the Fed will at least do something, I think my point with regard to market expectations is very much intact.  Yesterday on his blog, Paul Krugman posted a hypothetical entitled “If I Were King Bernanke” in which he put forward the following idea:

What I’d do if I were really in charge of the Fed, however, is the same thing I advocated for Japan way back when: announce a fairly high inflation target over an extended period, and commit to meeting that target.

… Something like a commitment to achieve 5 percent annual inflation over the next 5 years — or, perhaps better, to hit a price level 28 percent higher at the end of 2015 than the level today.

Although Bernanke is not precisely heeding Krugman’s advice, I think from an investors perspective we should interpret it quite similarly.  Putting aside all the theory and dogma, at essence in QE 2 is Bernanke’s (and the Fed’s) fear that inflation remains below our target rate of 2%.  Following that concept to the next logical step, Bernanke has tipped his hand to the market that he will actively pursue policies to stimulate inflation so long as it does in fact remain below 2%.

This is very important.  It is a clear signal that the Fed perceives the risk of deflation as a far more serious threat than inflation right now.  Further, it is an equally clear signal to long-run investors that allocating money towards stocks is preferable to bonds right now.  In economics, the cliche that “actions speak louder than words” is not completely true.  Language is a very important tool through which policymakers can shape economic expectations, and as such, investors must listen.