US muddles through a catch-22

Almost four years ago, the US Federal Reserve took the unprecedented step of cutting its policy interest rate to zero. The Fed cannot cut interest rates below zero, which means that since then it has undertaken a raft of other radical monetary policy actions. Included in these actions has been a couple of bouts of quantitative easing (QE, or printing money) and other bond purchases as it desperately tries to engineer a meaningful and sustained economic recovery.

The economic quicksand that resulted from the US banking crisis and wealth destruction from the collapse in house prices is deep. So deep in fact that after all this time and stimulus, there are serious doubts about the ability of the US economy to grow at a pace that anyone, including the Fed and its chairman, Ben Bernanke, would consider respectable.

The recent economic news is mediocre at best. While employment growth has returned, it is only just strong enough to match population growth. The unemployment rate, as a result, remains above 8 per cent and the participation rate is falling at an alarming rate. The recent GDP figures were tepid, at best, with annual growth floundering around 1.5 per cent.

This economic malaise is why the markets expect a further round of QE in the not too distant future. The Fed has already signalled, in an extremely transparent fashion, that it will be keeping its policy interest rate at zero until 2014. This means, very simply, that it will need to reach into its bag of policy tricks for other policy options as it tries to lift the economy out of the doldrums.

The Fed is getting no help from the policy makers in Washington. On the contrary, there is a large and powerful lobby, mainly on the Republican side of politics, that is pushing for fiscal austerity. In the drama and theatre of the presidential election campaign that still has three months to run, and in the context of the annual US budget deficit still around $900 billion (5.5 per cent of GDP), they may have a point. Fiscal policy cannot run large deficits forever. Net government debt is currently 76 per cent of GDP and on current settings, will exceed 86 per cent of GDP in 2016.

For those wishing to see economic and employment growth, such fiscal austerity would seem ridiculous. A progressive policy approach would be to inflate the economy with fiscal stimulus that increased the budget deficit and added to debt, but there would be the benefit from this of boosting spending, activity and jobs.

Here is the catch-22. Fiscal austerity measures to address the government debt problems will further weaken an already weak economy. Fiscal stimulus to support growth and support employment will add to an already high level of government debt.

As a result of this policy impasse, fiscal policy in the US is likely to muddle along over the next few years, doing little to alter the path of economic growth or the unemployment rate, nor changing the profile for budget deficits and government debt.

All of which means that it will fall to the Fed to manage the business cycle which, translated, means looking for new ways to stimulate growth.

Which is where we come back to where we started.

There seems no doubt that another round of QE beckons – the only debate is when, how much and what form it takes. The current market thoughts are that the Fed will act at its September policy meeting with the next bout of QE and for the focus of that to be on purchases of mortgages and corporate bonds. The current yields in the government bond market suggest earlier efforts to drive yields lower in this market have been successful with 2-year yields at a staggering 0.25 per cent while 10-year yields are around 1.5 per cent.

When the Fed delivers the next round of QE, it will help to lower the yields for corporate borrowers and lower the risk of corporate debt default, which obviously will support the economy. The concern is, will it be enough?

The rest of the world is registering sluggish and slowing growth, the US household sector is still reeling from years of wealth destruction and the US dollar is too high as investors shun the euro and the Chinese keep the yuan artificially low. This makes the prospects for the US economy problematic.

This is not good news. For now, the US economy is still the largest in the world and its stock and bond markets are the foundation of global market trends. Unless the US economy does pick up, get set for another few years of sluggish growth, falling commodity prices and incredibly low interest rates.

Stephen Koukoulas is an economist and financial market strategist who between October 2010 and July 2011, was economic policy advisor to Prime Minister Julia Gillard.

Follow @TheKouk on Twitter.