This week Ben Bernanke is likely to announce a new programme of "large-scale asset purchases". The aim of quantitative easing is to dispel deflation and reduce unemployment. Yet the plan is beset with controversy. It's not clear whether it will have much effect on the real economy or whether the Federal Reserve chairman has fully considered the long-term consequences of his unconventional policy. Investors have already bid up asset prices in anticipation of the central bank's move. But the financial gains from quantitative easing are a fool's gold.

It is generally agreed that a bout of quantitative easing in 2008 succeeded in calming the markets. But conditions are different today. The credit system is not dislocated and banks are willing to lend, according to the Fed's survey of senior loan officers. The problem is not with the supply of credit but with lacklustre demand from the private sector. Any new money created by the central bank expanding its balance sheet may well end up adding to the existing pile of more than $1,000 billion (Dh3,670 billion) of excess reserves in the banking system.

Quantitative easing is also intended to reduce unemployment, which remains at very elevated levels. But much of the current unemployment may be structural in nature. People who can't find a job because they are in the wrong place with the wrong skills won't find their prospects improved by the central bank acquiring Treasury bonds.

Nor will lower rates help many consumers.

Tilting at windmills

After the recent decline in house prices, about half of US homeowners find themselves owing more than their homes are worth and are thus unable to refinance. And since long-term rates in the US are already so low, quantitative easing is unlikely to promote much new business investment.

Bernanke is tilting at windmills. Not only is deflation absent in the US, it is arguable whether mild deflation is economically damaging. And even if it were, no one knows whether asset purchases by the central bank could succeed in reversing a deflationary tide. After the great credit binge, deflation reflects the desire of households and companies to pay down their excessive debts. It is a symptom, not a cause, of a problem. The experience of Japan over recent decades shows that deleveraging does not end because long-term rates decline. This explains why the Bank of Japan believes quantitative easing is futile.

Bernanke hopes that by boosting asset prices, consumers will spend more. But as Tim Lee of Pi Economics points out, this implies a further decline in saving at a time when the country's net savings rate is negative. The US needs to save and invest more to ensure its long-term prosperity. Quantitative easing threatens to postpone the necessary rebalancing of the US economy.

The fiscal consequences of quantitative easing are also troubling. The financial crisis has put the nation's finances in disarray. The 2010 US fiscal deficit will be about nine per cent of GDP. With the Fed ready to monetise a great chunk of the government's spending, there is even less chance that Washington will exercise fiscal discipline.

Risky assets

Quantitative easing involves the manipulation of household balance sheets by the central bank. As a result, asset prices are distorted and bubbles are inflated (as GMO's Jeremy Grantham explains in his latest Quarterly Letter). Over recent months the markets have anticipated QE2 by rushing indiscriminately into risky assets.

Valuations have become extended. At current levels, US equities offer poor future returns and Treasury bonds are very overvalued. The Fed may succeed in distorting asset prices in the short run, but it cannot do so indefinitely. People who have been misled into spending more today because of a temporary improvement to their balance sheets will have to retrench at some future date.

The international consequences of quantitative easing are also deleterious. Over the past couple of months the dollar has weakened as liquidity has flowed towards the higher-yielding currencies in emerging markets. The recipients of unwanted capital inflows have been forced to buy dollars to prevent their currencies appreciating. But foreign exchange interventions serve to loosen domestic monetary conditions in emerging markets, producing inflation and asset price bubbles.

This explains why several countries, including South Korea, are considering the introduction of capital controls.

In recent months, brokers have eagerly anticipated the launch of QE2. Their clients have been enjoined with nautical metaphors to "ride the liquidity wave". But they have identified the wrong ship and the wrong location for the cruise. Rather than steering towards balmy waters, Captain Bernanke has set course towards the iceberg fields. Full speed ahead!

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