The 2010 see-saw continues as equity markets more than recovered losses from August - in fact the Dow Jones Industrial Average had its best September in over 70 years. This is certainly not a result of improved economic reports as nearly all important measures of economic output, including industrial production, housing and employment are essentially flat over the last three months and most remain far below pre-recession levels. The most recent press release from the Conference Board notes that "latest data from the U.S. Leading Economic Indicators suggest little change in economic conditions over the next few months. Expect more of the same - a weak economy with little forward momentum through 2010 and early 2011." The source of the most recent rally has been the increasing belief amongst investors that the Federal Reserve will engage in another round of "quantitative easing". This is a form of monetary policy used by central banks to increase the supply of money in an economy when the primary interest rate is at or near zero. The actual mechanism for doing this is that the Fed will credit its own account (create money out of air) and use that credit to buy some kind of financial asset, usually government bonds from banking institutions. As you probably recall, the Federal Reserve last engaged in this behavior in a yearlong program started in March 2009 in which they purchased $1.2 trillion of government backed mortgage bonds. The goal would be to encourage businesses and individuals to borrow money due to low interest rates and at the same time ensuring banks have sufficient reserves to make those loans. It also tends to increase the value of financial assets as the increased supply of money has to find a home somewhere. Those are the desired longer term results but, of course, financial markets tend to discount such policy actions in real time and the immediate effect has been a decline in the U.S. dollar and gains in commodity and equity markets.

The selloff in the dollar is due to the fact that quantitative easing reduces the rates of interest in an economy while at the same time increasing the risk of higher inflation sometime further down the road. This has translated into higher prices in hard commodities because they tend to be safer stores of value in times of inflation. While a weaker dollar does not always equate with higher stock prices (over the long term we would argue the opposite) the negative correlation over the last month has been undeniable as you can see on the chart below.

Part of this is due to the fact that U.S. exporters benefit from a lower dollar as their sales in foreign currencies are suddenly more valuable. More of it is from the hope that further quantitative easing will provide real stimulus to the economy and perhaps kick start employment.

What are the downsides to quantitative easing? Well the most immediate is to anybody who actually has savings as the interest they receive goes lower while the potential for inflation gets higher. Those on fixed incomes can also be negatively affected. The government recently announced that Social Security beneficiaries will not get an increase for a second straight year. Knowing that the government is pursuing an inflationary policy at the same time your income is staying flat is pretty disconcerting. It is also questionable whether the policy will be effective. The Japanese have been pursuing similar policies on and off over the last decade without a sustained period of economic growth. The point of injecting money into the system is to encourage bank lending. The graph below compares the growth in Federal Reserve credit with the growth in total commercial bank lending since the start of the financial crisis. This indicates that while the Fed has aggressively pushed money into the banking system, that money has not resulted in more credit being extended by banks. Instead it has been used to cover bank losses and increase their reserves. There is no guarantee that further additions to the money supply will be any different.

Finally, a weaker dollar is not a desired outcome for most of our trading partners. It can translate into volatile and unpredictable prices and put their companies at competitive disadvantage. Thailand has already introduced measures to limit the appreciation in its currency and that trend seems likely to spread. A global round of competitive devaluations could be devastating to trade and is probably the worst possible outcome for all involved.