The scene is set for QE3

When inflation is soaring, gold is at all-time highs, and oil is well over $100 a barrel, it’s hard for policymakers to announce additional economic stimulus, since they will be accused of recklessness and of fuelling inflation.

Today however, it is not inflation that concerns G20 finance ministers, it is deflation that keeps them awake at night, and this gives them the justification they need to fire up the printing presses once more.

The Fed only has a narrow window in which to act

The Fed is currently still carrying out Operation Twist, which involves swapping shorter maturity US government bonds (Treasury bills) for longer maturity ones, but the programme comes to an end in June.

Operation Twist (which I consider to be QE2.5) has helped drive down long-term interest rates and has therefore helped reduce the cost of issuing new debt and refinancing existing debt. It has also kept mortgage rates low which has provided vital support the struggling US housing market.

As the chart below shows, the end of both QE1 and QE2 was accompanied by a selloff in the S&P 500 (and other major stock markets), and with Operation Twist coming to an end next month we could see further market falls – something the Fed would rather avoid.

Chart of the S&P 500 index with QE1, 2 and 2.5 overlaid on top

 Source: Barclays Capital

As we get nearer to the US presidential election in November the likelihood of seeing stimulus from the Fed diminishes, since it cannot be seen to have a political motive for is policy actions. As a result all eyes are on the two-day meeting that’s scheduled for 19-20 June. This is now the most likely date at with the Fed will at least hint at further “monetary easing”.

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