QE3 is a done deal. That at least is the tale of the freshly falling dollar, rising gold and plummeting bond yields. The market is convinced of the following logic. The US economy is slowing down, fiscal policy is off the table, leaving any action to the Federal Reserve. Interest rates are already zero, so the only option, just like last year, is more bond purchases. QE3 QED.
This logic is correct as far as it goes, but investors are taking it too far, too fast. First, they should ask what the Fed wanted to achieve with the last round of QE (buying bonds to push down yields). Chairman Ben Bernanke is famously an expert on depressions and deflation. Last autumn’s QE2 followed a sharp dip in inflation expectations, derived from the bond market, to 1.5 per cent per year over the next 10 years. On this measure, QE2 worked. Inflation expectations are falling again, but remain within the pre-crisis range at 2.2 per cent. No need for QE3 there.
Second, the Fed wanted to push up risky asset prices and thus stimulate investment. It succeeded. QE2 started after a significant correction for stocks. The FTSE-All World index was no higher than it had been a year earlier. Now, risk assets are wobbling and lacking in direction; but there has been no wholesale correction.