QE2 inflates commodities, threatens 70s-styled malaise

QE2 is a rising tide that lifts all boats. The boats, in this case, refers to asset prices. Unfortunately, not all asset rallies are good for the real economy.

Since the Federal Reserve first strongly telegraphed on September 21st that it will conducted a second round of large-scale asset purchases with newly-printed money, risk assets have jumped across the board.

The S&P 500 has risen 4.5 percent, gold has climbed 8.2 percent, oil has gained 16.8 percent, and copper has rallied 14.1 percent.

Rising equities is certainly helpful for the real economy. It helps households and institutions repair balance sheets and pay down debt. Overall confidence may also rise, although it is debatable how much confidence this reflation-based rally will generate.

However, rising industrial and consumer commodity prices is harmful to the real economy. The average U.S. household spends about 10 percent of its income on gasoline and utilities, so rising commodity prices will crowd out spending in other areas, dampen confidence, and hamper the deleveraging process.

For businesses, it's the same story, with commodity-dependent industries suffering the most.

Rising gold prices, on the other hand, hurts a few industries, funnels money into a largely unproductive channel, and perhaps undermines the credibility of the U.S. dollar.

Eduardo Lopez, an official with the International Energy Agency, and Andy Xie, the former chief Asia-Pacific economist of Morgan Stanley, have both raised the possibility that QE2-induced booms in commodity prices could hurt the real economy.

The stagflation of 1970s serves as a warning and real example.

In 1973 and 1979, the United States was hit by two severe oil shocks and the whole decade was marked by elevated unemployment and interrupted economic growth.

From 1973 to 1975, the unemployment rate peaked at 9 percent, the stock market dropped 45 percent from peak to trough, and GDP contracted 3.2 percent from peak to trough.

Furthermore, the prolonged economic malaise coincided with high inflation, which remained above 5 percent per year from 1973 to 1982. This historic occurrence of high inflation is also a relevant concern because of the Federal Reserve recently expanded the money supply by huge amounts.

Email Hao Li in New York at hao.li@ibtimes.com.