Published March 23, 2009

breakingviews.com
Quantitative easing a crucial test for Bernanke

By EDWARD HADAS
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BEN Bernanke hasn't had it easy lately. So the governor of the Federal Reserve should remember Wednesday, March 18. For one brief day, he seemed to have regained the upper hand over frightened markets. It didn't last - for good reasons.

Investors were shocked by the announcement that the Fed would buy US$300 billion of US government debt, with the prospect of much more to come. For most, the shock was a pleasant one. Treasury yields fell sharply, stocks rose and the spreads on credit default swaps narrowed.

Actually, one important market baulked at the Bernanke touch, even on Wednesday. The US dollar fell 3 per cent against a basket of currencies. But by Thursday, the overall investor mood had shifted from awe to worry. Stock markets retraced their gains and commodity prices jumped.

There are two concerns. First, quantitative easing (QE) might not have the desired immediate effect of healing the financial system's wounds. The Japanese experience of QE, the most relevant example, is not encouraging. Little of the central bank's newly created money was spent. Asset prices hardly rose and economic activity didn't pick up. It could have been worse, but it could have been much better.



Second, quantitative easing might have the undesired eventual effect of unleashing uncontrolled inflation. Some critics fear consumers and businesses will spend all their new cash too fast for the Fed to manage. Others see QE, which lets the government spend more than it takes in without needing to borrow on the market, as an invitation to ruinous fiscal policy.

What next? Massive government spending, in the US and elsewhere, could stabilise economies. There are already a few positive signs. The next iteration of the US bank rescue plans, or a strong action plan from the G20, could turn confidence around.

But quantitative easing - now being tried in the US, UK and Japan - is crucial. If it does what Mr Bernanke hopes it will, the former Princeton professor will be lauded for his ability to put economic theory into practice. But if the radical QE works no better than recent less extreme Fed policies, Mr Bernanke can expect more bad days in the markets.