No QE3 for now

Hopes for a third round of quantitative easing from the Federal Reserve were dashed on Friday, at least for the time being.

In his speech at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, Fed Chairman Ben Bernanke gave no signal of further monetary stimulus. He said that the Fed expected the recovery in the United States economy to continue and strengthen.

Bernanke did not rule out further stimulus. He acknowledged that economic growth during the first half of this year was considerably slower than expected. There was also an “extraordinarily high level” of long-term unemployment. Therefore, the Fed was prepared to continue to consider a range of tools that could be used to provide additional monetary stimulus.

Nevertheless, Bernanke said that “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank”. He said that fiscal policy had a role. He said that “fiscal policy must be placed on a sustainable path” but taking into account the “fragility” of the current economic recovery.

Is Bernanke's decision not to proceed with another round of quantitative easing immediately correct? The answer, of course, depends on where you think the economy is headed.

On the day of Bernanke's speech at Jackson Hole, the Commerce Department also released data showing that the estimate for second quarter economic growth had been revised down from an annualised rate of 1.3 percent to 1.0 percent. This followed a growth rate of just 0.4 percent in the first quarter. Clearly, the US economy grew below trend in the first half of 2011.

While Bernanke said in his speech that the Fed expects the economic recovery to strengthen, another report on Friday casts some doubt on such a prospect. The Thomson Reuters/University of Michigan sentiment index fell to 55.7 in August from 63.7 in July. Sharp declines in this index have in the past often been associated with recessions.

On the other hand, there is a possibility that past monetary stimulus may finally be gaining traction. Economist and television show host Larry Kudlow noted on 18 August that the monetary indicator M2 has been “soaring”. As Kudlow said, strong M2 growth usually signals a fast-growing economy.

Unfortunately, M2 appears to have lost some of its value as a leading indicator in recent years, as the following chart shows.

Indeed, Kudlow does not think that the latest surge is good news. Rather, he thinks that it actually reflects a flight to safety.

“There’s a flight to government-guaranteed accounts,” he wrote. “Some people believe Europeans are withdrawing from their own banking system and parking their money in the U.S. banking system, guaranteed by Uncle Sam.”

“So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk,” Kudlow concluded.

And deflation risk, of course, was exactly what triggered the previous rounds of quantitative easing.

So do not rule out QE3 completely yet.