Will Quantitative Easing Fool Most People?

The Federal Reserve Board is set to wind down much of its quantitative easing program and specifically its purchases of mortgage backed securities by "March 31, 2010". It remains to be seen how coincidental it is that the very next day is April Fool's.

The Fed has been overseeing a giant game of Chicken, with inflation and deflation staring each other down. Deflation is defined as a contraction of credit and no one can argue that we are getting just that. But with a trillion federal reserve notes fluttering down from the sky like a heavy snowfall, it's not difficult to forecast a vicious inflation for our future.

But inflation is not quite here yet despite the most massive and deliberate attempt by central banks worldwide to create one. And that may speak to just how strong the current deflationary forces are. Despite the availability of cheap money, banks are largely satisfied with investing in Treasury securities. Then again, long dated Treasury yields are being artificially tamped down by Fed purchases of those securities.

Or maybe the economy's problems are not completely a monetary phenomenon, but a human one. Despite spectacular liquidity, banks aren't all that optimistic. Isn't that what JP Morgan (JPM) CEO Jamie Diamond meant by his words on his company's quarterly conference call? When asked about raising the dividend he said the board wanted to be sure there isn't another "dip" out there. That's dip as in "double dip, another leg lower in the economy.

I too want to be sure there isn't another dip. But that's only half the risk because if credit keeps contracting things may become worse than a dip. If Fed policies don't work to stave off deflation and fiscal policy fires a trillion of its own bullets to no affect, credit may continue to contract. And what if when that process winds down in a couple years, it is followed by a massive inflation? We get both, and most of us will have been fooled by both.

With the stock market 100% of the way back to pre-Lehman (LEHMQ.PK) levels, it would be wise to keep a sharp eye out for a dip in the road as the margin for error in equity valuations may be nil.

Disclosure: no long or short positons mentioned