Bernanke prepares for a third round of fire

The US Fed, along with the ECB, is almost certainly set to announce another round of easing within two weeks... the only question is what form these will take.

More than two million. 

That is the US Federal Reserve’s estimate of the number of private sector jobs created because of its radical quantitative easing program over the last couple of years. The Fed purchases of bonds and mortgage-backed securities has had the direct effect of pushing yields lower, maintaining liquidity and in the process has lowered borrowing costs for corporate borrowers and mortgage holders. QE is a little like an interest rate cut for the bond market.

This is how QE was meant to work… and it has.

The critics, often confused in their expectations of what QE can deliver, say that QE has not engineered an enduring economic recovery. It clearly hasn’t, but neither has anything else. A counter-factual analysis where there is no QE would show real GDP in the US about 3 per cent smaller than it is today, 2 million fewer jobs and an unemployment rate near 10 per cent.

Perhaps this shows how dreadfully fractured the US economy and banks are, even with zero interest rates and trillions of dollars of QE.

As it is, US GDP growth has averaged a sub-optimal 2 per cent over the past year, having slipped to just 1.7 per cent in the most recent quarter.  The unemployment rate is currently 8.3 per cent, below the recent peak of 10 per cent in October 2009, but it has barely moved in since the start of the year. The unemployment rate was near 4 per cent in 2007.

The economy is still sluggish and in the past few months the outlook has, if anything, soured. After a brief uptick around the start of 2012, business and consumer sentiment are now falling. Government demand, both at the federal and state and local level, is not adding to GDP growth. The current consensus is for US GDP to grow by just 2 per cent in 2013 and as a result, the unemployment rate will be lucky to fall much below 8 per cent, if at all.

These dynamics quite simply mean further policy stimulus is needed.

The political situation, America’s entrenched budget deficits and the near $16 trillion of government debt mean that fiscal policy will not be used to stimulate economic activity and jobs. The Fed has had the policy interest rate at zero for almost four years and clearly cannot cut interest rates any more. 

Which brings us to Bernanke’s speech at Jackson Hole over our weekend. The speech moved markets – stocks were higher, the US dollar was lower, commodity prices rose, bond yields fell – all because Bernanke said, very simply, that "we should not rule out the further use of such policies if economic conditions warrant”.

By not ruling them out, Bernanke is ruling then in. The Fed is about to deliver another round of QE. The questions are when and in what form the next round of QE will take. The Federal Open Markets Committee meets next on September 12 and 13 and it would be odd, after the clear signals from Bernanke, if there was no additional QE announced at that time.

And there clearly should be more policy easing.

Bernanke hit the nail on the head when he said that prolonged periods high unemployment caused "enormous suffering and waste of human talent”.  Perhaps even more tellingly, he suggested the current level of unemployment was imposing "structural damage on our economy that could last for many years”.

In other words, the social and economic costs from high unemployment are untenable. Something must be done.

The next instalment of QE from the Fed is likely to be preceded this week with the European Central Bank announcing its own monetary policy stimulus through QE. 

The ECB Policy Committee meets Thursday and it is the first chance for ECB President Mario Draghi to put actions to his words that the ECB will do "whatever it takes” to keep the eurozone together. Buying the bonds of Greece, Spain and Italy would certainly show Draghi’s resolve.

It appears there is some serious and growing discord from some members of the policy committee. Bundesbank President Jens Weidmann is against the ECB buying sovereign bonds, as are other senior Bundesbank officials. It appears that for the sake of unity, they will support ECB action later this week, but only on the condition that tough austerity measures are kept in place from the governments of the countries which benefit from the bond purchases.

All of which makes for a watershed fortnight coming up. With the ECB and the US set to ramp up their radical monetary policy settings, the markets are desperately hoping for a large dose of stimulus.  Without it, or even a watered down version, market risk could increase and with it, stocks will unwind their recent gains.