Bernanke's twisted choice

Ben Bernanke appears to have realised QE3 will hurt a large part of America, but he can only keep the market dangling for so long.

Is US central bank boss Ben Bernanke finally questioning the benefits of QE3?

That seems to be the message following the Fed’s decision overnight not to launch a third round of quantitative easing – dubbed QE3 – which would see it embarking on an aggressive bond-buying spree.

Instead, the Fed decided to continue with its much more modest 'Operation Twist' program, under which it sells short-term bonds, and uses the proceeds to buy long-term bonds with the aim of pushing long-term interest rates lower. The original $400 billion 'Operation Twist' program – which kicked off last September – had been due to expire at the end of this month. But last night’s decision means that the Fed will be busy "twisting” until the end of the year, buying $267 billion of long-term bonds (with maturities between six and 30 years) and selling bonds that mature in three years or less.

Now, the Fed’s decision to shy away from more aggressive stimulus – even though it conceded that the US economic outlook was gloomier than previously thought – appears to indicate that Bernanke is becoming increasingly aware of the economic and social costs that quantitative easing produces.

Investors were desperately hoping for a new bout of QE3, because when the US central bank embarks on a massive bond-buying spree, it injects a massive amount of liquidity into markets, and this drives US and global stock markets higher. Some of this extra liquidity also sloshes over into commodity markets, pushing up prices for goods such as oil and copper. In fact, after the Fed’s last bond-buying spree – QE2 – wholesale gasoline prices rose by more than stock prices, and other commodity prices saw big jumps.

The trouble is that many small and medium-sized US companies see their profit margins squeezed when prices for oil and other commodities rise steeply. And when households are forced to spend more buying petrol for their cars, or on heating their houses, they have little choice but to cut back their spending on non-essential items. Because it pushes up the cost of living, QE actually undermines the living standard of millions of low- and middle-income households in America.

Bernanke appears to have realised that a fresh round of QE3 would actually exacerbate the income and wealth divide in America. The wealthy – who own large share portfolios – would benefit as stock prices push higher, while the rest of the country would likely end up being decidedly worse off.

But Bernanke is desperate to avoid the vicious market meltdown that would likely occur if he voiced his concerns about QE. So last night he kept markets in a state of hope by promising that the Fed is "prepared to take further action as appropriate” to boost the economy. And investors, who initially reacted petulantly to the Fed’s decision not to give the green light to QE3, consoled themselves with the idea that it was only likely to be a temporary delay.

But there is only so long Bernanke can keep investors dangling. Within the next few months, he faces an invidious choice: either he can dash market hopes for QE3, or he can launch a new bond-buying program, knowing all too well its negative social and economic side effects.