The U.S. Federal Reserve Board’s move to introduce a second round of quantitative easing reflects the reality that much needed fiscal stimulus is unlikely in the United States, says BMO Capital Markets.

In a research note, BMO suggests that, ideally, the initial U.S. fiscal stimulus should have been bigger.

“Early in the recession, the U.S. should have increased government spending significantly more than they did on high-value projects (say high-speed trains, alternative energy, education and medical research) in the context of a longer-term plan to cut government spending and revamp the tax system.”

Sufficient fiscal stimulus “would have allowed the Fed to refrain from additional quantitative easing and reduce its balance sheet as the economy recovered” it notes.

However, the political reality did not allow for a bigger stimulus package, and BMO indicates that it is unlikely that any new fiscal stimulus will get through the new Congress, after the recent mid-term elections. “Cognizant of this reality, the Fed introduced QE2 to help offset the unintentional fiscal tightening that is occurring,” BMO says.

“Given the politics in the U.S., China and the rest of the world, QE2 may well be the only way the Fed could attempt to forestall the contractionary effects of the fiscal tightening that is already in place, not to mention what might be yet to come,” it says.

BMO indicates that there is a limit to how effective QE2 will be in boosting the housing market, “but it is still better than nothing”, and it notes that there is some recent evidence of improving economic data in the U.S.

Looking ahead, it suggests that, amid Congressional gridlock, the expiring Bush tax cuts may be extended, and that nothing much may happen on the spending side in 2011, “in which case, the Fed will play it by ear, continuing to ease as long as the economy appears to be sluggish and inflation weak.”

IE