Where to next for Bernanke?

Financial markets rallied overnight, as investors consoled themselves with the thought that the economic outlook is now so bleak the US central bank will have no choice but to administer a fresh batch of stimulus.

Certainly, US central bank boss Ben Bernanke painted an extremely grim picture of the US economy when he appeared before Congress overnight. Growth, he conceded, appears to be decelerating; business investment is likely to weaken, and progress in reducing the country's 8.2 per cent unemployment rate is likely to be "frustratingly slow”.

Although there were faint glimmers of hope that the US housing market could finally be improving, Bernanke noted that potential house-buyers remain worried about the outlook for their own finances, and for the economy more generally. Others are unable to borrow money to buy houses because the banks have tightened their lending standards, or because their existing mortgages exceed the value of their houses.

Against this dismal backdrop, investors took heart that the smooth-talking Bernanke appeared to offer the balm of extra monetary stimulus, even though he refused to spell out exactly what measures he had in mind.

Bernanke, himself, had reason to tread carefully. He'll have a clear memory of the market sell-off he sparked last month, when he announced that the Fed would not be launching a major stimulus program, but would only be continuing its much more modest ‘Operation Twist' program until the end of the year.

Overnight, he was careful not to dash market hopes, and instead ran through all the tools that the Fed had at its disposal. It could, for instance, extend its plan for keeping interest rates low, or it could reduce the interest rate it pays banks on their excess reserves. Alternatively, it could buy more US government bonds and mortgage-backed securities in an effort to drive down interest rates – a step known as quantitative easing.

Deep down, however, Bernanke knows that all these measures are problematic. Investors know that Bernanke's term as chairman expires in 2014, and are likely to discount any promises he makes on interest rates beyond that point. And the US central bank has previously thought about reducing the rate it pays banks, but has rejected it for fear of disrupting short-term money markets.

What's more Bernanke is aware that a third round of quantitative easing – dubbed QE3 – will do little to boost the economy at a time when consumers, worried about their future job prospects, are fearful of spending, while businesses, worried about future sales, are reluctant to invest or to hire new workers.

Indeed, QE3 could even hammer consumer and business confidence further. Investors are baying for QE3 because when the US central bank buys up huge quantities of bonds, it injects a massive amount of liquidity into markets, which drives US and global stock markets higher. But this liquidity also spills over into commodity markets, driving up prices for goods such as oil and copper – for instance, after the US Fed's last bond buying spree, QE2, there was a bigger jump in wholesale gasoline prices than in share prices.

The trouble is that when oil prices rise, many small and medium-sized US companies suffer a squeeze on their profit margins. And households, which have no choice but to spend more to heat their houses and to fill up their cars, quickly cut their spending on non-essential goods. Because QE pushes up the cost of living, it actually undermines the living standard for millions of low and middle-income households. The wealthy – those lucky enough to own large share portfolios – benefit from rising equity markets, but most of the rest of the country ends up being decidedly worse off.

But, Bernanke appears increasingly cornered. He's reluctant to embark on QE3 for fear that it will damage the real economy, and undermine business and consumer confidence. But he's also worried of triggering a major market sell-off – which would also damage confidence – if investors give up hope that QE3 is on its way.