Most investors think QE2 is a luxury cruise ship but it is actually one of the most controversial Federal Reserve policies in recent history.

After lowering the Federal funds rates to near zero, quantitative easing is one of the last weapons in the Fed's arsenal to reignite the US economy. Let us first go over what exactly quantitative easing ('QE') is and why the Federal Reserve is announcing its intentions this week.

In conducting QE, the Federal Reserve essentially goes out and buys securities (usually US Treasury bonds).

QE has three basic operating targets. First, it hopes to lower long-term interest rates, possibly driving the real (inflation adjusted) interest rate to negative levels in hopes of stimulating loan demand and discouraging savings. The second desired outcome is to increase the supply of lendable reserves in the banking system which may lead to increased output and employment which may also lead to increases in equity prices and the subsequent boost in the wealth effect.

There is a big problem, in our view, with these objectives. The supply side of the equation is not constrained. That is, there is ample liquidity in the system. In fact, US commercial banks already hold $1.066 trillion of reserves with the Fed, and another $1.626 trillion in Treasury and agency securities, an all-time high.

The real problem is the demand side. You can lead a horse to water but you can't force it to drink. It is quite obvious that the US economy is in somewhat of a liquidity trap. This trap arises when lending rates are already extremely low yet loan demand is elusive.

Basically no one wants a loan. They are too busy paying off their old ones (or defaulting). In general, neither businesses nor consumers are finding attractive borrowing opportunities and they may also lack confidence in their ability to pay off new borrowings due to future uncertainties.

The secondary impact of this policy is a weaker US dollar as investors seek higher yielding currencies.

Lowering the trade-weighted value of the US dollar will not necessarily lead to a more vibrant export market. Boosting the level of exports in a country is far more complex than simply making your currency cheaper (I have discussed this in my previous column on 'Currency Wars'). As a result, it is our opinion that the Fed's actions will have little economic effect.

It may, however, affect assets prices depending on the ultimate size of the announced purchases. Wall Street analysts' estimates vary from $70 to $120 billion of asset purchases per month for six months.

As a point of reference, the US has about $100 billion a month in net new Treasury issuance. So if the Fed were to embark on a sequence of purchases in this range it would essentially be absorbing the entire federal deficit for the QE2 period.

A large purchase programme may drive down yields and or support equity prices. Stock markets may rally on the belief that a large QE programme will eventually work to revive the economy and head off any potential slowdown in the economy.

In fact, one obvious effect of lower risk free yields is that it lowers the opportunity cost of taking risk (i.e. it makes risk assets look much cheaper by comparison). Gold could rally if the size of QE is thought to be very inflationary.

The ultimate outcome on asset prices is difficult to predict because the market has already been pricing in at least some QE. The announcement of the programme will be right after the US elections on November 3 and the size and details of the programme will determine near term asset price changes.