Will Ben Bernanke Launch a QE3?

The question of what Ben Bernanke will do once the bond purchase program expires in June is regarded as the most important determinant of long-term market direction by those who believe that the recovery phase is illusory. If the U.S. economy can gather its own momentum in the meantime and begin to charge forward without such a great dependence financial markets trends, the role of the central bank would also be relegated to secondary rank. With little sign of such a development, one can expect the trading community to remain under the spell of Fed for some time to come. As the Fed`s largest active intervention in the markets, it is clear that the bond purchase program is of crucial role in setting trends.

In order to understand what the Fed will do, we need to adopt a more rigorous approach in our assessment of the Chairman`s policies. We know a lot about his character, ideological outlook, his teachers, and his roadmap for an exit from the economic downturn. But perhaps more importantly than these, we know that his freedom of movement, great as it is, is in fact limited by the legally-defined mandate of the institution he leads - he must keep inflation low, while striving towards a practical goal of full employment. In this aspect at least we have a fairly good idea on what drives his actions and words. Since nobody questions the integrity of the Chairman, we are safe in the basic assumption that we know what his ultimate goal in setting policy is, even though this goal frequently becomes obscured by his effort to reconcile various conflicting interests (administration vs. Congress, public vs. corporations, etc.)

The pivotal point in the debate surrounding another possible leg of liquidity pumping must then focus on what aspect of his mission the Chairman has achieved during this governorate term. Although inflation has generally been higher than the declared target of the Fed, it has remained stable and tolerable, with hints that it is not going to increase dramatically anytime soon. In spite of the worries and concerns that this is temporary, neither inflation expectations nor actual price movements show any risk of runaway price rises at the moment. This means that the Fed has succeeded in achieving its mission with respect to this side of its dual mandate. The other side of the governor`s mission, however, focusing on growth and especially employment, have not been so successful. The unemployment rate remains high, credit for small businesses is improving but still difficult to obtain, and the general outlook for economic activity is  better but not particularly encouraging, judging from the tone and tenor of the chairman`s comments in recent weeks.

As a consequence, we believe that the odds are tilted toward a resumption of purchases before the end of the year. Apart from the problems faced by the U.S. economy itself, the problems of international finance and the global economy in general should keep unemployment at elevated levels for some time, discouraging risk taking and heavy hiring activity, and this will prove unpalatable to the Fed sooner or later. Assuming that the Chinese must increase interest rates, the Europeans must resolve their domestic problems, and that the Middle East turmoil has a long time to go, it is but a matter of time that the Fed, encouraged by persistently low inflation, will move to yet another leg of QE3. The timing itself will depend only on when and how the market panics, with the Chairman having little role in the decision process, although he always gets to have the final say as the unwilling mouthpiece of speculators.