Bernanke’s Twist sharpens year-end stimulus anxiety

Fragile Economy

“The Fed has repeatedly underestimated how fragile the economy is,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. Policy makers are “being a little too optimistic that all they need to do is nudge the economy back on course and then they can stop.”

Bernanke said June 20 he sees “a lot of uncertainty” about the economic outlook because of slowing global growth and financial volatility stemming from Europe’s credit crisis.

Figures from the Munich-based Ifo institute today showed German business confidence dropped in June to the lowest level in more than two years. In Italy, a measure of consumer sentiment fell to the weakest level since 1996.

The fiscal cliff in the U.S. would result in a “very substantial withdrawal of income from the economy” that would damage the expansion, Bernanke said at a press conference this week after the FOMC decision. The Fed is “prepared to take additional steps if appropriate,” he said.

Limiting Damage

The tax increases and spending cuts would trim a combined 3 percentage points from growth next year, according to economists surveyed last month by Bloomberg News. Political compromises would limit the damage to 0.8 percentage point, sustaining the expansion, the survey showed.

Harris predicts the Fed will announce a third round of asset purchases in September, partly to minimize damage to the economy from fiscal cutbacks. He has maintained his forecast for 1.9 percent growth in 2012 since last year and projects a 1.4 percent expansion in 2013.

“Right now, there’s a guessing game about when the Fed intervenes,” he said. Announcing an open-ended program conditional on the economy’s health “would reduce the uncertainty around what the Fed’s objectives are.”

Bernanke in a 2004 speech described how monetary policy typically changes in a gradual way. In times when the economic outlook is unclear, central bankers tend to change the benchmark interest rate in small steps over time while gathering fresh information.

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