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By Richard Blackden Economics Last updated: March 29th, 2012
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Ben Bernanke, the chairman of the Federal Reserve (pictured here) has been cautious about the US recovery
Over the last three years, it has become the Federal Reserve's version of the waiting game cardinals make the world play when they elect a new Pope.
What's at stake is, of course, different. It's not about who will lead the world's more than one billion Catholics, but whether the Fed has anything left up its sleeve to help America's economic recovery.
No smoke emerges from the Fed's historic Eccles Building in Washington as it does from a chimney on the roof of the Sistine Chapel in Rome. The breathless audience isn't crammed inside St. Peter's Square, but instead sit in front of banks of Bloomberg and Reuters terminals on trading floors in financial capitals.
What the processes have in common, though, are drama and ritual. This week we got the latest installment from the Fed when its chairman, Ben Bernanke, gave a speech on unemployment on Monday. There was no explicit reference to any further measures the Fed will take, but Bernanke was sufficiently downbeat for Wall Street to believe he hasn't ruled out a third round of quantitative easing.
His pessimism wasn't just down to the fact he was speaking at 8am on a Monday morning. While welcoming the sharp drop in the unemployment rate in the last six months - from 9.1pc to 8.3pc - Bernanke and others among the Fed's top brass clearly believe that it is overstating the strength of the wider economy.
If the drop is going to be sustained, he suggested, it's going to require a recovery in consumer demand of a different order than we have so far seen. Indeed, he told ABC News this week that "it's far too early to declare victory."
Although Bernanke's analysis of the unemployment picture was interesting, it wasn't a totally convincing justification for the scepticism he showed this week, and indeed has all year, about the chances of the US recovery meaningfully strengthening in 2012.
A better explanation may instead lie in the testimony he gave to Congress on February 29 in which he warned politicians not to allow the US to fall off a "fiscal cliff" at the end of the year.
He wasn't joking. As things stand, Americans will see in 2013 with a bonfire of tax increases. The cuts in income tax first introduced by President George W Bush expire. So too does the cut in the tax that employees pay that was agreed last December. Alongside both those passing their sell by date, emergency unemployment benefits are set to finish.
Then, two weeks into the year, $1.2trillion in automatic spending cuts are due to start because the Congressional Supercommittee – and don't worry if you don't remember it – failed to agree cuts of their own in the autumn.
Adding it all up, economists at Bank of America estimate that it amounts to a fiscal contraction of between 3.5pc and 4pc of the country's gross domestic product. To put that in perspective, the IMF says that Britain's fiscal contraction last year amounted to 1.7pc of GDP and another 1.6pc is due this year.
New Year's Eve is shaping up to be one to remember because Democrats and Republicans have spent the past 18 months putting off uncomfortable decisions on fiscal policy. Immediate retrenchment would have hit the recovery, but clarity on a long-term plan to address the country's debt would have helped.
The bad news is that the picture doesn't look any better for the next nine months. Barring a major external shock that forces the hand of both parties, there won't be any agreement before November's presidential election.
So that leaves a narrow window beginning the day after the election and running until December 31 for a lame duck session of Congress – so-called because some of those sitting won't have been re-elected to the new session that starts on January 1 – to ensure the economy stays the right side of the cliff.
Despite the real philosophical differences that divide the parties and the bitterness that exists between pockets on either side, it's impossible to imagine that the lame duck Congress will do nothing. Instead, it's highly probable that the various tax cuts will be temporarily extended so that the new Congress can make decisions in early 2013.
That in itself is unlikely to make Bernanke sleep easily at night. Given the scale of the uncertainty businesses and consumers will face over tax and spending policies, it's easy to imagine spending and investing slows in the second half of the year.
And that brings us back to the possibility of a third round of quantitative easing. Bernanke has signalled the central bank will do more QE if the economy does slow. While stock markets would no doubt be juiced by the prospect of more asset purchases, the policy will carry serious risks. The central bank would face the accusation that monetary policy is being used to compensate for the failures to reach any agreement on fiscal policy.
Of course, if the economy keeps creating jobs at the pace it has over the last six months, the damage caused by the uncertainty Americans face over fiscal policy should be greatly reduced.
Bernanke has plenty of reasons for keeping his fingers crossed that his own relative pessimism about the unemployment rate this year proves wrong.
Tags: Ben Bernanke, Federal Reserve Quantitative easing, Fiscal contraction, US economy
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