QE3 sails into view

The US central bank is grappling with the thorny problem of how to apply an extra monetary stimulus to the US economy before the upcoming presidential election, without triggering a rise in politically sensitive petrol prices.

Many economists believe that the US Federal Reserve will embark on a new round of quantitative easing by mid-year to try to ensure the US economy is humming along by the time that the US presidential campaign gets underway in earnest. And they point out that there's some room for stimulus, particularly as the US unemployment rate remains high.

What's more, they point out that the US economy is likely to lose steam in coming months. In recent months, growth has been boosted as companies replenished their inventories, and consumers satisfied their pent-up demand, particularly for automobiles. But the boost from inventory restocking is already fading, and falling house prices will douse any recovery in spending by the vast US middle class.

US growth will also be dragged down further as governments – state, local and federal – step up their efforts to cut spending and boost taxes. Many state and local governments are likely to introduce further budget cuts from the beginning of July, when most start new fiscal years. And the US federal government faces a major fiscal consolidation next year as the compulsory spending reductions and tax hikes – agreed during last year's rancorous negotiations over the debt ceiling – take effect. Indeed, Ben Bernanke, the boss of the US central bank, warned the US Congress that it risks taking the economy over a "massive fiscal cliff" if it allows the Bush tax rates and a payroll tax cut to expire and $1.2 trillion in spending cuts to be implemented simultaneously in January.

As a result, many economists are now tipping that the US central bank will be quick to act at the first signs of a slow-down. And their hopes of another round of stimulus – already dubbed QE3 – were boosted by a recent Wall Street Journal report by Jon Hilsenrath – a reporter with exceptionally good Fed contacts. According to Hilsenrath, Fed officials are considering a new type of bond-buying program if it decides to take further steps to boost the economy in coming months.

Under the new approach, the US central bank would print new money and buy long-term Treasury or mortgage bonds. However, it would restrict the amount of money sloshing around in the financial system by borrowing the money back from investors for short periods by using transactions known as "reverse repos”.

Using this approach, the US central bank believes that it will reduce fears about a future inflationary outbreak. It believes that inflationary fears cause investors to rush into risk assets, pushing up the prices of stocks and commodities.

Many analysts argue that the US central bank's previous stimulus policies have failed to boost economic growth because they have pushed commodity prices – especially food and fuel prices – higher. With the cost of basic necessities rising faster than wage increases, US consumers were forced to cut back spending on other discretionary items.

According to the WSJ report, Fed officials are unlikely to launch new stimulus programs at next week's meeting. However, "if growth disappoints or inflation slows substantially, Fed officials might at some point decide to act again.”