FED´S DANGER OF LEAKS WITH QE / THE WALL STREET JOURNAL ( RECOMMENDED READING )

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OCTOBER 17, 2010, 4:46 P.M. ET.

Fed's Danger of Leaks With QE

By KELLY EVANS

Ben Bernanke has opened the door to further policy easing in the U.S. His challenge now may be to keep investors from exiting through it.


In the past, the Federal Reserve's efforts to stimulate the U.S. economy have been fairly straightforward. Lower interest rates to push investors out of cash and into riskier investments like stocks and real estate. Repeat until it sparks a recovery. The process becomes much more fraught, however, when investors have other, more attractive assets—and other countries—to choose from.


That is the risk right now, especially as central banks in other regions such as Europe seem determined not to pursue the same degree of policy easing as the Fed.


Already, the protection against dollar debasement and inflation offered by commodities and precious metals is luring investors. So are the greater growth prospects of emerging markets. Emerging-market equity funds, including ETFs, have taken in nearly $60 billion year-to-date, according to EPFR Global. Global precious metals and commodity funds have added about $19 billion. U.S. equity funds, meanwhile, have seen $50 billion of outflows.


Most Fed officials would argue this isn't worth losing sleep over. The more money that flows into emerging economies, the more it should lift demand for U.S. exports. The more that stokes inflation abroad, the more it should help avoid deflation at home.


But further quantitative easing risks creating new distortions while falling short of the Fed's aim to reduce the nation's 9.6% unemployment rate. Export-led growth, if it can be achieved, is likely to come from more capital-intensive than labor-intensive industries. The manufacturing sector, for example, has added 114,000 workers this year but now employs just 11.6 million workers, a third fewer than it did a decade ago. Trade, transportation and warehousing, meanwhile, employ far more U.S. workers—about 29 million total—but have added proportionately fewer jobs, some 176,000, so far this year.


European Central Bank official Lorenzo Bini Smaghi singled this out this concern in a recent speech. "If anything, keeping the cost of capital excessively low may encourage capital-intensive investment, rather than labor-intensive capital expenditure," he said. "Monetary policy cannot, by itself, transform a jobless recovery into a job-generating recovery."


There is another risk too: that investor preference for gold and other stores of value pushes the Fed's new money into a hole. IHS Global Insight economist Brian Bethune calls it the gold trap: Investors are parking their funds in nonproductive assets like gold that undermine the Fed's efforts to simulate activity.


The SPDR Gold Trust ETF has seen roughly $6 billion of inflows this year, according to Morningstar, and now has some $50 billion in assets. That is still pretty small in the scheme of things, but the Fed hasn't yet officially embarked on its next round of quantitative easing.


Policy makers may find it tougher than expected to inflate this leaky balloon.


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