Bernanke put here to stay

2012-MAY-24

In the United States it often feels as if the market has been put on hold while investors sit and wait to get further resolution as to “what the Fed’s gonna do next”. While many in the Austrian crowd have felt for quite a while that further easing will be forthcoming, there is still a large segment of the market that believes the economy is recovering and there will be no QE3. Where do we stand now with regards this seemingly never-ending QE3 speculation?

Though economic indicators were improving over last autumn and winter, the data has been getting worse again  – as indicated by a recent Philly Fed survey on manufacturing, and various consumer confidence readings. Investors are looking for reasons to be hopeful, yet here we are four years after the subprime summer of 2008, and unemployment remains stubbornly high while real growth remains negative.

Fed minutes were released last week that included a shift in the tone of language used about the prospect of more easing. While they did not lay out specific criteria by which they would judge the need for more stimulus, they did note the eurozone crisis could lead to more pain for the US economy. They also noted that government spending cuts and/or tax increases could also be factors that may lead them towards further easing.

At the moment the European crisis looks worse than ever, with the situation in Greece and Spain continuing to deteriorate. Because of the refusal to take any sort of proactive action in writing down sovereign debt in any meaningful fashion, the probability of a disorderly event occurring continues to increase each day. A surprising comment out of Germany the other week that the Bundesbank is even considering allowing a greater rate of inflation is perhaps a clue in regards to the seriousness of the situation. Given the level of indebtedness of many (most) European nations, the continuing failure to adhere to austerity targets, and the seemingly obvious insolvency of the Greek government it is actually amazing that some sort of breaking point in this situation has not already occurred.

In terms of potential spending cuts or tax increases slowing down growth and serving as a basis for Fed action, think about the logic behind that statement. If the government follows through on plans to address the deficit then it will lead to easing. But what about the alternative? If the deficits just continue to grow and there is no plan to finance them then how does that not eventually get resolved with more QE as well? In either case the outlook for the dollar doe not look good.

At this point the US economy has passed the point where it is possible for a natural recovery to occur without significant short-term pain. The malinvestment caused by previous stimulus needs to be processed with bad debt being allowed to fail. The alternative is more printing. Since Bernanke has been clear that he will not allow deflation, then more QE remains highly probable.