QE3 becomes more likely

The combination of recent sharp falls in risk assets, the worsening global growth outlook, and anticipated weakness in commodity prices could pave the way for further quantitative easing.  
Recent sharp falls in stock markets have been attributed to worse than expected US economic activity data and the ongoing problems in the euro-zone. The sharp declines in risk assets raises the prospect of QE3 from the Federal Reserve. Last August, Ben Bernanke announced QE2 at the Jackson Hole conference after markets had fallen sharply (see chart right). Stocks rallied on the announcement but have weakened significantly since QE2 ended in June 2011.

Inflation/commodities outlook appears to make QE3 viable...
Inflation expectations have fallen back after peaking in major western developed markets in April 2011.

- The outlook for commodity prices is key. Prices of industrial commodities like oil and base metals could be expected to weaken due to the deteriorating global growth outlook.

- Commodities have been a key driver of inflationary pressures, so a correction in commodities would make quantitative easing more likely.   

- Five-year breakeven inflation expectations have fallen recently in the US, Germany and the UK after peaking earlier this year.

- The US 5-year breakeven is now lower than it was when QE2 was announced.

- This could help central bankers justify a further round of quantitative easing.

Is the Bernanke put set to make a reappearance?
Ben Bernanke, the Chairman of the Federal Reserve, has admitted targeting weak stock prices with previous rounds of quantitative easing. This has given rise to the concept of the ‘Bernanke put’ - the feeling in stock markets that Bernanke will act to support market levels when necessary on the basis that higher markets can, via wealth effects, help the real economy.

“This approach eased financial conditions in the past {…}. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.” Ben Bernanke, Chairman of the US Federal Reserve, Washington Post, November 2010

Bernanke has been reluctant to discuss additional monetary easing until now. However, given weaker data and the recent declines in stock markets, it might not take much more bad news to change his mind. The annual Jackson Hole conference in late August could be the setting for more fireworks.

“With growth likely to slow and fiscal policy frozen, we expect to see a further round of monetary ease by year end and this should ultimately benefit stocks and commodities. However, barring a major upset in the markets, central banks will want to wait until inflation subsides before taking action. In the meantime, the current environment points towards holding a well-diversified portfolio.”  
Trevor Greetham, Head of Multi-Asset Funds at Fidelity

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