Bernanke poised for a QE fusillade

The global economic policy easing trend is set to extend to the US tonight, Australian time, with the Federal Reserve set to add the next instalment of quantitative easing into a sluggish US economy.

Last week, the European Central Bank implemented a radical bond purchasing strategy as it tried to kick-start growth and at the same time allow for the repair of the parlous fiscal conditions in many member countries. In China, a $170 billion infrastructure spending program has been implemented as the authorities try to arrest the slowdown that is threatening to see the economy slow to its lowest growth rate since the financial crisis.

Tonight it will be the US Fed which will be forced to act, following some particularly poor labour market data which added to a run of less than impressive news on the US economy.

The urgency for further QE is highlighted by the follow stark facts on the US labour market.

The unemployment rate was 8.1 per cent in August and has now been above 8 per cent for 40 straight months. We have to go back to 1948 to see the last time the unemployment rate was stuck at such a high level for such a protracted period of time.

At the same time, the workforce participation rate fell to a 31-year low of 63.5 per cent, to be 2.5 percentage points lower than the level of just two years ago. What makes this free-fall in the participation rate important is a counterfactual calculation that suggests the unemployment rate would be close to 11 per cent had those who dropped out of participating in the labour force been counted as unemployed.

This huge amount of space capacity in the labour market – both people unemployed and those having left the labour market – shows up in the wages data. Average hourly earnings growth was just 1.7 per cent in the year to August. This is slowest rate of increase since the new definition to hourly earnings was applied in 2007 and it is one of the weakest wages increases in many decades.

Here is where we bring in the Fed and its chairman, Ben Bernanke. Everyone, especially Bernanke, knows that there poor results mean that something needs to be done to trigger a lift in growth that will drive a pick up in employment.

At his speech just almost two weeks ago at Jackson Hole, Bernanke reiterated the fact that the Fed has a duel mandate, that of "maximum employment” as well as price stability. In another none-to-subtle demonstration of the importance of the labour market to Bernanke policy thinking and probable actions, he said that "labour force utilisation remains at very low levels” and that "improvement in the labour market has been painfully slow.”

In judging the Fed's likely actions tonight, the simple point is to note that Bernanke rounded out his Jackson Hole speech by saying "...Unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time."

While the need for policy easing is obviously urgent, it is not clear what form the new round of QE will take. Suffice to say that more Fed buying of US Treasuries and mortgage backed securities will be important to keep overall yields lower and to support the housing mortgage market. There seems little doubt that the Fed will also reiterate its commitment to holding the policy interest rate at "exceptionally low levels” for an extended period, which translates to near zero interest rates to 2014, and perhaps beyond.

In the past rounds of QE, the Fed has quantified the limits on its operations and while there have been no practical problems with this, as soon as the last dollar of bond intervention has been made, the markets have become nervous about what's next. This is especially the case with the less than impressive economic news that keeps flowing. There is speculation that the Fed will follow the ECB lead and leave the bond buying program open-ended, thereby linking the policy action to economic recovery and success in boosting employment, rather than capping it at some arbitrary dollar value.

The fact that the recovery in the US has seen only 4.1 million jobs being created after 8.8 million were lost during the recession highlights the need for policy action. These grim statistics are made to look even worse when one considers the fact that the working age population has risen by around 6 million people over the same time frame.

The interesting issue about the policy debate in the US, and efforts to lock in a decent rate of economic expansion, is that fiscal policy stimulus is now largely off limits. The Tea Party extremists have successfully hijacked fiscal policy, meaning that much needed fiscal measures to promote growth are not happening. Indeed, the US is implementing fiscal cutbacks when it needs stimulus. In the current economic circumstances that is absurd.

But the final word is from Bernanke's Jackson Hole speech: "the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labour market conditions.” Bring in QE3.