US midterms: easing the economy amid political gridlock

Later today the Fed chairman, Ben Bernanke, is expected to sanction a second round of money creation by America’s central bank through the policy known as quantitative easing – or QE. The amounts involved are uncertain at this stage, but likely to be staggering – $500bn seems to be the hot tip from the markets, though $1 trillion is also being talked about.

Those numbers are difficult to comprehend – all the more so when you realise that this comes on top of $1.7 trillion that the Fed has already pumped in the US economy earlier in the year

The Fed is taking this action because the US economic recovery is stumbling – unemployment remains high and house prices have started to fall again. The housing situation could prove particularly tricky because falling prices pose a threat to the US banking system, which leant so much in the boom years to home owners who are now struggling to repay those mortgages.

Quantitative Easing

So how is Quantitative Easing (QE) meant to help this situation?

The reality is that parts of the Republican Party are already sceptical about the Fed’s actions.

The plan is that the Federal Reserve will buy US government bonds from private investors. Buying the bonds will help to drive down interest rates across the economy and pump cash into the financial system which might just make lending conditions a bit easier for consumers and businesses.

That’s the theory. But QE is a controversial policy because people aren’t sure whether it’s working – if pumping in $1.7 trillion hasn’t worked, what’s the point of another $500bn? Others suspect that it’s just storing up trouble for the future by building up inflationary pressure in the economy.

Here’s where the Fed’s actions intersect with what’s happening in the American political system right now. One view is that the Fed will be encouraged to do more QE because it sees that there’s little chance of any future fiscal stimulus from the politicians – and if anything, there may be moves to cut spending in the US to rein in the country’s enormous budget deficit.

But there are risks for the Fed if that is part of their reasoning. The reality is that parts of the Republican Party are already sceptical about the Fed’s actions.

Risk

They worry that Mr Bernanke appears to have enormous power but with little political control. Some in the Tea Party would go so far as to scrap the Federal Reserve entirely.

So for the Fed, an aggressive move on QE could bring more criticism from the politicians – an uncomfortable position for an institution whose reputation and influence depends on its ability to stand above the political fray.

For the rest of the world, the worst outcome might be a US economy drifting back towards recession, but with no decisive action from either the politicians or the central bank to turn the tide.