Weaker US economy to bring QE3

A faltering recovery in the US economy could cause the Federal Reserve to start a third round of quantitative easing later this year, although this provides mixed signals for equity markets.

Figures released next Friday are expected to show that the real economy grew at a relatively healthy looking annualised rate of almost 3 per cent in the first quarter, but many economists believe growth has been flattered by unseasonably mild weather and will slow down soon. The International Monetary Fund forecast this week that US GDP will grow by only 2.1 per cent this year, and Ethan Harris at Bank of America Merrill Lynch expects just 1.9 per cent growth.

Corroborating these concerns, some recent indicators have, says Tom Porcelli at RBC, "been decidedly on the soft side". Manufacturing output fell 0.2 per cent in March; housing starts dropped by 5.8 per cent; and net non-farm employment rose by just 120,000, its slowest rate for five months.

Mr Porcelli says the combination of slower growth, a fall in inflation, and worries about the effects of the eurozone's debt crisis will "make the case for another round of QE". Mr Harris says: "We expect the Fed to wait for clear evidence that growth is faltering and then adopt a new round of unconventional easing."

Although no one expects the Fed to do this at next Wednesday's meeting, it could hint that it will consider such a policy at future meetings. But Mr Harris says QE is a "relatively inefficient stimulus tool", and the Fed regards it as a way of nudging the economy towards recovery, rather than as a quick fix.

And this might be needed to offset a tighter fiscal policy. David Greenlaw at Morgan Stanley warns that the expiry of temporary tax cuts and unemployment benefit increases, and some cuts in public spending, could cause "a fiscal tightening of unprecedented magnitude" next year – equivalent to 5 per cent of GDP. Congress will attempt to avert most of this, but no one knows when it will do so, or by how much. This uncertainty will depress business investment, adding to the case for quantitative easing.

Traditionally, the mix of a loose monetary and tight fiscal policy has caused a lower exchange rate, which may give manufacturers in emerging markets who are complaining about the weak dollar more to worry about. Previous rounds of QE have induced rallies in equity markets but the underlying message, that the US economic recovery may be faltering, could prove to be a drag on equities in the longer term.

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