Ben Bernanke’s Mission Impossible

Stocks and commodities performed strongly yesterday, helped by chatter about plans for a eurozone “banking union,” whereby the European Commission in Brussels would take the lead on banking legislation from European Union member states. European stocks had one of their strongest up days of the year in response, while the Dow recorded its strongest session of the year – up nearly 2.5% to 12,414. The euro gained 1% against the dollar, moving back above $1.255.

Crude oil and gold also put in strong showings – at one stage gold moving just above $1,640 – though the yellow metal lost ground later in the session following unexpectedly optimistic Federal Reserve comments about the US economy that gave no hint of more quantitative easing being imminent. However, Fed chairman Ben Bernanke is due to testify before Congress today from 10am EDT (3pm BST), and traders will as ever be scanning his every utterance – perhaps even his body language – for hints as to whether “QE3” is coming. So if gold and silver prices shoot dramatically higher later, as they have a habit of doing whenever Bernanke steps in front of a microphone, you’ll know why.

Of course, the opposite prospect is also a possibility – that of Bernanke downplaying the chances of more QE, in which cases expect a sell-off in stocks, commodities and precious metals. As we saw yesterday when the European Central Bank kept rates at 1%, despite rumours that they would cut them, central banks can still disappoint cheap money fans from time to time.

Moreover, Bernanke has a difficult balancing act to play. The Fed wants to see the velocity of money increase in the US economy, which can only happen if people start spending again. In order for them to do this, they need to feel optimistic about the economy, which means Bernanke and his deputies need to “talk up” the economy where possible. But this happy talk necessarily reduces QE3 expectations, which depresses stocks and commodities, strengthens the dollar, and leads to reduced inflation expectations.

Thus the Fed faces its own kind of catch-22 situation: sound optimistic about the economy in an effort to ignite people’s “animal spirits” and stocks sell off. Sound pessimistic about the economy and stocks rise with increasing QE3 expectations, but you then encourage people to save money and refrain from borrowing. Not an easy circle to square.