The 'QE2' project was supposed to ease borrowing and get consumers to spend again. Instead, it has benefited only a few while raising most people's cost of living.

Cream to the top

Yes, the stock market has posted impressive gains since the idea of QE2 surfaced, with the Standard & Poor's 500 Index up nearly 31% from its low last August. And that has pushed up household net worth by $2 trillion. The hope has been that this will translate into new spending and drive the economy forward.

But stock ownership is concentrated among the wealthy: On average, just 12% of households worth $100,000 or less own stocks and mutual fund shares outside their retirement plans -- a group that comprises 74% of the total population. While many more own shares through 401ks and IRAs, they're not in a position to easily tap that wealth for current spending.

At the same time, QE2 has pushed up borrowing costs, pressing down the prices of homes -- a much more widely held asset. The Case-Shiller Home Price Index started falling last summer as the idea of QE2 was floated, and it hasn't stopped since. The broad 20-city index now sits below 2009 levels.

This is a continuation of trends that have been in place since the recession ended in 2009. According to Credit Suisse equity strategist Douglas Cliggott, it suggests the improvement in net worth during the past two and half years "has been heavily skewed towards that relatively small part of the U.S. population that has significant equity holdings."

In other words, the Fed's "stimulus" has made the rich richer, with limited impact in terms of new spending. It's made the vast majority of people poorer, and less able to spend. It's this tradeoff that threatens to snuff out the feeble, three-year-old economic recovery.

Disappointing GDP

Just look at the first-quarter GDP growth numbers released last week. Most people just aren't spending.

The government reported that GDP growth slowed to 1.8% annualized from 3.1% in the fourth quarter -- a dramatic slowdown at a time when both QE2 and the government's payroll tax cut were in full effect. Indeed, Paul Ashworth at Capital Economics was disappointed enough to tell his clients that given all the tailwinds, he had "originally hoped for a lot more."

The drop was due mainly to bad weather, higher energy prices and a decline in consumer spending. The last two of these factors, at least, are set to continue with the budget fight under way and commodity prices still high. Consumption growth slowed to 2.7% from 4% previously -- mainly due to a drop of nearly 50% in spending on goods such as motor vehicles and groceries. Government consumption dropped 5.2%, which whacked 1.1% from overall GDP growth.

Unfortunately, while Fed Chairman Ben Bernankeinsisted last week that any negative factors are "transitory," the data suggest otherwise. The Kansas City Fed Manufacturing Composite Index was just the latest regional factory survey to suggest production is slowing. And as I mentioned in my last column, the Citigroup U.S. Economic Surprise Index continues to decline to reflect this slowdown in manufacturing.

All of this hurts the job picture. Weekly jobless claims spiked to 429,000 last week, well above the previous week's 404,000 and the 390,000 that analysts were expecting. Current levels were last seen in January. Not only does this point to trouble in the April job report due out Friday, but it breaks a long downtrend from last summer that suggested economic healing.

A flawed idea from the start

I can't say I'm surprised. Last November, I wrote that QE2 threatened a repeat of the "Great Inflation era" that started in 1964, lasted 20 years and didn't end until inflation was at 15% and interest rates at 22%. In "Hiking inflation won't help, Ben," I wrote:

"It seems strange to have this discussion more than a year after the recession officially ended, after corporate profits have returned to pre-recession peaks, after the economy has created 1.6 million new jobs and after personal income has moved to new highs."

There was no credit panic. Interest rates were not high. There was not a lack of liquidity. But the concern was that inflation was too low and job growth too slow. So the Fed decided to push another $600 billion worth of cheap cash into the financial system by buying back bonds, despite the fact that the banks were holding nearly a trillion dollars in "extra" cash in their vaults.

Bernanke himself, when he introduced the idea of QE2 at a central bank gathering in August, said the maximum benefit would be seen during a period of "economic and financial stress" via a lowering of borrowing costs for businesses and households. Only later -- after interest rates started rising instead of falling -- did he focus on the idea of raising stock prices as a major goal of QE2.

The decision-making was flawed.

As I wrote back then, inflation was pushing off its lows and moving higher. Bond market activity was suggesting a very low chance of sustained deflation, a deeply feared cycle of falling prices. And early indicators of economic growth were improving. Job growth -- while slow because of structural issues the Fed cannot solve -- was reaccelerating.

While it's true that stocks sold off last summer on European debt fears, the ability of businesses to borrow cheaply in the bond market and use the cash to buy back shares or engage in merger-and-acquisition activity was keeping the economy moving and funneling cash into stocks. Interbank lending rates -- a key measure of stress in the financial system -- hardly budged. It appears that the Fed, encouraged by Wall Street, overreacted to fears of a double-dip recession.

We didn't need QE2. But we got it anyway.

The benefits never materialized

We haven't gotten the promised results, however. We are more than $400 billion into QE2, and the benefits that helped secure popular support for the move have not arrived.

We have not gotten lower borrowing costs. Instead, expectations of higher inflation have pushed interest rates higher. That has pushed up the cost of credit cards and of mortgages, damaging the fragile housing market. From a low of 2.5% in November, 10-year Treasury bond rates stand at 3.3% now after spiking to 3.8% in February. Banks, instead of easing their lending practices, have squirreled away more money and now hold nearly $1.4 trillion in total excess cash.

It's worth noting that those higher interest rates don't reflect rising economic growth expectations, as some of the Fed's defenders have claimed. According to Capital Economics, the "real" or inflation-adjusted interest rate, which reflects economic growth expectations, has managed to climb to only 0.8% from the 0.4% low reached in October. Over the same period, inflation expectations have climbed. Translation: Bond traders are looking for mediocre growth and more inflation, not a good combination.

We certainly can't blame rising prices entirely on the Fed. There have been protests and political revolutions throughout North Africa and the Middle East -- tightening the energy supply situation. And there have been droughts and crop failures -- tightening the food supply situation.

But the recent feverish rise of gold and silver has demonstrated that the Fed has dumped enough cheap cash into the system to allow speculators and momentum traders to run amok. And their escapades are damaging the real economy and the financial security of working Americans.

Last November, I spoke with an expert on the Fed, Allan Meltzer, who penned "A History of the Federal Reserve" and served in both the Kennedy and Reagan administrations.

I checked in with him again recently to see if he still thought the move was "foolish." His criticisms have only sharpened. He believes that the Fed's QE2 initiative was "unnecessary and mistaken" and agrees that it has resulted in more inflation, higher commodity prices and a devalued dollar.

Wall Street is also getting worried that instead of being a benevolent force, the Fed's money printing is doing damage. Cliggott, the Credit Suisse equity strategist, summarizes our situation like this:

"So here we are -- a mix of really bad weather, rapid growth in most of the largest developing economies, and political and social conflict in Africa and the Middle East have together conspired to turn what was meant to be a soothing rain of excess liquidity in the United States that would help heal the labor market into some uncomfortably hot inflation patterns that are weakening the real purchasing power of millions of American households."

And now the fallout

So where do we go from here? Last week, I laid out the case for a period of underperformance in the stock market as the negative effects of QE2 filter into the economy. (Read "Investors, it's time to run and hide.") This looks likely to continue, since the program has another two months to run -- keeping pressure on food and fuel prices and consumer spending.

A surge of inflation is likely despite the fact that the unemployment rate is still close to 9% and factory output is well off of its pre-recession highs. Such is the nature of our economic malaise. Remember that high unemployment doesn't preclude higher inflation: Spain's unemployment stands at 21.3% while its inflation rate has increased to 3.8%.

Meltzer believes the Fed is making the same mistakes it made in the 1970s, focusing too much on unemployment while ignoring the inflation threat. The Fed dismisses that threat as transitory and says inflation expectations remain under control.

This is "simply wrong" according to Meltzer, since inflationary pressures reflect real, lasting shifts in the supply/demand balance as countries like China grow and those like Saudi Arabia struggle to feed their growing appetite for resources. And while unemployment is a problem, "it's not a monetary problem."

As a result, the Fed is pushing money into an expansion -- a dangerous and inflationary move. According to Meltzer, "Bernanke has committed himself to this. He doesn't want to admit he's wrong and he's dragging others with him."