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Ray Dalio worries the Fed's QE may run out of gas

Ray Dalio
Scott Eells | Bloomberg | Getty Images

Ray Dalio's hedge fund, Bridgewater, just put out a note suggesting the the biggest worry for markets should not be about the Fed tapering quantitative easing. It should be about the diminishing effects of QE.

The first point is relatively straight forward. The Fed has said it will slow and eventually cease its bond buying program when the economy shows signs that it is strong enough to withstand a removal of QE. This should mean that the taper shouldn't be a big deal: it will signal a removal of support for the economy at the same time as signaling that the economy no longer needs the support. Which is to say, we'll be transitioning from federal stimulus to market-generated stimulus.

So what happens if things don't go as planned? If the taper is premature or the economy subsequently contracts, the Fed should be able to turn around and reverse the taper. That is, restore QE or even increase it. So, again, the taper should be basically a non-event. Or, at most a temporary blip in the recovery.

The real worry, according to the folks at Bridgewater, is that further bond buying might just not work. QE might be close to the limit of its effectiveness.

Here's an excerpt from Bridgewater's note (as excerpted on ZeroHedge):

Quantitative easing today is driving asset prices to unsustainable levels, without stimulating much additional activity. That leaves a much clearer tradeoff between driving up asset prices today and lowering future returns (the price of which will be paid in the future). During the crisis period, that was much less the case, because pulling forward returns from the future (i.e., raising prices) was then also creating future earnings growth (by helping to normalize the economy).

The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.

We think the question around the effectiveness of continued QE (and not the tapering, which gets all the headlines) is the big deal. Given the way the Fed has said it will act, any tapering will be in response to changes in US conditions, and any deterioration that occurs because of the Fed pulling back would just be met by a reacceleration of that stimulation. So the degree and pace of tapering will for the most part be a reflection and not a driver of conditions, and won't matter that much. What will matter much more is the efficacy of Fed stimulation going forward.

In other words, we're not worried about whether the Fed is going to hit or release the gas pedal, we're worried about whether there's much gas left in the tank and what will happen if there isn't.

Bridgewater's view obviously matters a lot because it is one of the world's largest hedge funds and its founder and leader, Ray Dalio, is regarded as one of the best observers of market and economic conditions alive today. When Bridgewater worries that Fed stimulus is becoming ineffective, it's a good idea to pay attention.

(Read more: The weird world of Ray Dalio)

That said, I'm not sure that Bridgewater's analysis is as complete as it needs to be. Notice that Bridgewater views the effectiveness of QE as arising from two things: 1) satisfying a demand for cash and 2) a portfolio effect that creates a wealth effect.

Here's how Bridgewater puts it earlier in the note:

... QE stimulates the economy by (1) offsetting a panic by providing cash to the financial system when there's a need for cash, and (2) by raising asset prices, and driving money from the assets they buy into demand and investment, creating a higher level of future economic activity.

What's left out here is the possibility that QE actually acts far more like traditional monetary policy by influencing expectations about future rate policy. This expectations channel, in fact, is the one that some of the most sophisticated monetary policy experts emphasize when they talk about the effectiveness of QE.

How does it work? Well, when the target rate is already at or close to zero, the Fed cannot further reduce current overnight rates. But it can reduce expectations about rates in the future if it can convince the market that rates will stay very low. What the Fed is doing, in other words, is reducing future rates through current policy.

(Read more: Dalio on the economy)

This has has all the effects on the economy that Bridgewater describes to traditional monetary policy, namely:

1) reducing debt service burdens which improved cash flows and spending, 2) making it easier to buy items marked on credit because the monthly payments declined, which raised demand (initially for interest rate sensitive items like durable goods and housing) and 3) producing a positive wealth effect because the lower interest rate would raise the present value of most investment assets (and we saw how raising interest rates has had the opposite effect).

The only way this can "run out of gas" is if the Fed loses the confidence of the market. That is, if QE no longer serves to convince market actors that rates will stay low for an extended period of time, it will no longer work. That's the real risk of this "communications" strategy: it only works so long as people believe the Fed.

—By CNBC's John Carney. Follow him on Twitter @Carney