Fed cautious about QE3

Bernanke's speech on Aug 26 sparked more speculation about whether US will launch another round of quantitative easing

Ben Bernanke, chairman of the United States Federal Reserve Board, made a speech on the US economic outlook at the annual meeting of the leaders of the world's central banks held in Jackson Hole, Wyoming, on Aug 26. Although, unlike his speech last year, he did not clearly announce the arrival of a new round of quantitative easing (QE3), his words still triggered a rebound on the US stock market.

Looking closely at his speech, we can see that the first priority of the speech was obviously to try and calm the market panic that followed the raising of the US debt ceiling, Standard and Poor's cutting of the US credit rating, and the growing sovereign debt crisis in Europe.

Whether the Fed can control the situation in the US was the news the markets wanted to hear. Bernanke gave the answer at the beginning of his speech when he said that although the recovery is slow and unstable the US economy is much stronger than it was during the onset of the financial crisis.

Bernanke's statement on the current economic situation was that the turmoil is temporary and the US economy is recovering as the growth fundamentals do not appear to have been permanently altered by the shocks of the last four years: the US manufacturing sector is beginning to grow, the trade deficit is narrowing gradually, household savings are increasing; and the price of commodities are beginning to fall.

However, his speech also indicated that the Fed is unable to control the situation by itself. He said the Fed's current policy is a combination of policies and the way to use them requires in-depth discussion. This suggests there is probably a huge side-effect to any other policy it might be tempted to use, so unless there is a really compelling reason to do so the Fed will not use them. As Bernanke said, the use of policy tools should not leave the US economy with a big wound.

Bernanke politely criticized the current model of deficit reduction, suggesting that it has affected the US economy. This is actually expressing the Fed's position that fiscal policy must play a role in promoting economic recovery. In other words, the Fed does not want to be the scapegoat for the absence of fiscal policy. He urged policymakers to deal with challenges that do not fall under the control of the Fed, such as high unemployment and the collapse of the housing market.

After reviewing the experience of economic recovery after World War II, Bernanke says this time we cannot look to the real estate sector for recovery. Instead credit and financing are being dragged down by the downturn in the real estate market. This means even if the Fed continues to lower financing costs, it will be difficult to reactivate the real estate market.

But about whether a new round of quantitative easing will be launched or not, Bernanke said nothing. The Fed will be cautious about the re-introduction of large doses of monetary policy. The effects of the second round of quantitative easing were reduced, and whether QE3 will make sense has become a hot topic for members of the US Federal Open Market Committee.

The political risks of QE3 are also bigger as the election is approaching and the side-effects of QE3 will pose problems for US politicians if the prices of gasoline and consumer goods increase.

Bernanke says the Fed expects the inflation rate to be below 2 percent in the next few quarters. However, after two rounds of quantitative easing, high inflation on a global scale is one of the inevitable effects of the policy. The US CPI increased 3.6 percent in July, and the core CPI also rose 1.8 percent. At this point inflation-control is the Fed's preferred option. As Bernanke said the Fed will certainly do all it can to help restore high rates of growth and employment in a context of price stability.

The market speculation is that if the US extends the Open Market Committee session in late September it will signal the arrival of QE3. Therefore, although there was no news about QE3 in Bernanke's speech, it was actually good news for the market.

The author is a researcher from China Institutes of Contemporary International Relations.

(China Daily 09/06/2011 page8)