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Stimulus spurs stocks to rise, then slide

| Saturday, Oct. 6, 2012, 9:32 p.m.

The multitrillion-dollar financial infusion ignited by the Federal Reserve and the European Central Bank last month created an explosion of confidence in stock and bond markets. As the dust settled last week, investors' renewed feeling of security gave way to anxiety.

Should pessimism spread, it will threaten the portfolios of market bulls and bears.

In the face of falling economic growth rates and high unemployment in the United States and other trade-linked key economies, such as the European Union, Goldman Sachs estimated that the Fed's new economic stimulus program, called QE3 — a third round of so-called quantitative easing — will reach $2 trillion. This is because more and more printed money will be necessary to lift confidence.

Adam Parker, Morgan Stanley's chief equity strategist, speculated that “the Fed [may] dramatically augment this program.” In other words, a QE4 now appears in the cards.

Stephen Jen, a hedge fund manager and a former Morgan Stanley foreign exchange expert, told The Financial Times that central banks “know everything except their own limitations.”

Such views expressed by top Wall Street executives are deeply concerning, especially as it becomes increasingly clear that past stimulus efforts are not working.

Banks are left with huge amounts of bad loans on their books. Bank regulators have allowed these loans to remain on the books as “performing” loans. However, even the banks realize the inherent credit unworthiness of these ‘toxic' loans. Banks, therefore, are willing to lend only on stringent terms against excellent credit.

In addition, regulators continue to allow banks and mortgage companies to hold toxic mortgages left on their books from the financial crisis.

In short, despite the injection of trillions of dollars, huge amounts of toxic loans and mortgages lie hidden within major financial institutions.

Recent stock market rallies have been followed by declines. This demonstrates a lack of sustainable investor confidence that central banks have the ability to fight mega economic trends. There is a growing perception that central banks are risking more than they can deliver.

Such uncertainty is cause for concern. The economies and financial markets of key nations are underpinned by a seemingly implacable faith in their central banks.

Historically, central banks engendered faith in their role as lenders of last resort. Today, their role has been expanded greatly to include market support, protection of the banking industry and even to act as an engine of economic growth.

There are two old and long honored Wall Street maxims: “Don't fight the Fed” and “The trend is your friend.” Today, the Fed appears to be fighting the trend. This raises serious questions about the Fed's likely success.

To a large extent, the American economy has become political. As such, far greater financial market volatility can be expected.

For the first time in generations, investors face the strategic challenge of investing not just in volatile markets. If central bank credibility falters seriously, there is a real risk of catastrophic price collapse in financial markets.

John Browne, a former member of Britain's Parliament, is a financial and economics columnist for Trib Total Media. Email him at johnbrowne70@yahoo.com

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