LONDON: Federal Reserve Chairman Ben Bernanke serves up a new set of clues this week that might help solve one of the thorniest riddles for the world economy: what will it take to make the US central bank ease monetary policy further?
Bernanke will present his semi-annual monetary policy report to Congress on Tuesday and Wednesday against a background of lacklustre growth at home and a festering sovereign debt crisis in Europe that is increasingly preoccupying US policymakers.
But investors will be lucky if Bernanke goes much further than the minutes released last week of the Fed's June 19-20 policy meeting. The central bank kept open the option of a third round of outright bond purchases, or quantitative easing (QE) in market jargon, if the economy took a marked turn for the worse, but appeared to set a high bar for such aggressive action.
"Right now the economic numbers are very mixed so I don't think Bernanke can make a clear, compelling commitment on QE at the current time," said David Hale, who runs a global economics consultancy in Winnetka, Illinois.
Growth might have been as soft as 1.5 percent in the second quarter, Hale said. But he also pointed to falling unemployment claims in recent weeks as well as a bounceback in auto sales and durable goods. Some forecasters were penciling in a pick-up in growth this quarter to an annual rate of 2.5 percent or 3.0 percent, he noted.
"So the situation is far too unclear," Hale said. "I think all he'll do is keep his options open and see what the economy looks like in September."
This week's batch of US economic data is unlikely to tip the scales one way or the other.
The first regional industry surveys for July, from New York and Philadelphia, are forecast to show a modest improvement; retail sales for June are expected to have edged up 0.1 percent on the month; headline inflation in the year to June probably ticked down to 1.6 percent but economists see no deflationary risk that could push the Fed off the fence.
If the economy does stumble or market confidence collapses, the Fed's initial response is likely be to indicate that interest rates, now expected to stay close to zero at least through late 2014, will remain exceptionally low for even longer.
Vince Reinhart, Morgan Stanley's chief US economist, believes the Fed's decision last month to buy an additional $267 billion in long-term bonds with proceeds from short-term debt - a measure known as Operation Twist - effectively puts the central bank's balance sheet on auto-pilot for the rest of the year.
"We think their first recourse will be to tweak their language about interest rates. From their perspective, a modest disappointment requires, at most, a modest policy response," Reinhart, a former senior Fed staffer himself, said in a note to clients.
EURO ZONE WOES
The wild card is the crisis enveloping the euro zone. Speaking in London last week, St Louis Fed President James Bullard listed a number of domestic impediments to US growth.
"But even more pressing is the situation in Europe. The crisis is contributing to recession, adding a dragging factor on US and Asian performance. There is a financial sector dimension which periodically threatens to expand into a more generalised financial crisis," Bullard said.
After Italy successfully navigated a bond auction on Friday despite a two-notch credit rating downgrade from Moody's Investors Service, the next such financial test of the euro zone comes on Thursday when Spain is due to tap the bond market.
Thanks to an agreement in principle to bail out Spanish banks to the tune of up to 100 billion euros ($122 billion)without adding to the state's debt, yields on 10-year Spanish bonds have fallen back from the 7 percent level widely deemed to be unsustainable.
Euro zone finance ministers will gather on Friday to put flesh on the bones of the Spanish deal, clinched in return for a further 65 billion euros in tax increases and spending cuts announced by Madrid last week.
Confirmation by ministers that the euro zone's rescue fund would not be paid out ahead of other creditors should Spain default would be a relief for bond investors. The losses imposed on private owners of Greek debt, while the official sector was spared, has accelerated a flight from the bonds of other heavily indebted countries such as Italy and Spain.
But many questions are likely to linger about the plan to help Spain, not least because the bailout is linked to plans for euro zone-wide supervision of the 17-nation area's biggest banks - a politically and technically fraught undertaking that will take months of preparation.
Gianluca Ziglio, an interest rate strategist at UBS, said the bank rescue was positive because Spain was relying on domestic buyers to refinance its debts.
"If you underpin your banks you are able to buy time. But in my view it will be just buying time. It's difficult to see how Spain can actually avoid a full-blown bailout," he said.
And, as Ben Bernanke knows all too well, that could touch off a financial tsunami that would hit economies far beyond Europe's shores.
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