Will the Fed do QE3?

June 3, 2011

Almost as soon as Friday morning’s disappointing jobs report crossed the wires, the Wall Street chatter began: Will there be QE3?

That would be another round of quantitative easing by the Federal Reserve, the central bank’s strategy of buying vast sums of Treasury bonds to try to increase the money supply and strengthen growth. The second round of such purchases, worth $600 billion, is ending this month.

The short answer to Wall Street’s question: Probably not.

The long answer: Don’t expect the Fed to announce a QE3, but the weak outlook likely will push off the day when the central bank will start tightening monetary policy — sucking money out of the economy — to an even more distant horizon.

The lousy unemployment report comes on the heels of other disappointing economic data, but Fed officials view the current situation as different from the conditions that led to last year’s bond-buying. The recent round of data is neither alarming enough nor definitive enough to make them reconsider the unconventional monetary policy.

For one, much of the economic slowdown in the first half of the year was likely driven by temporary factors. The Japanese earthquake and tsunami appear to have disrupted the supply chain at U.S. factories more than initial forecasts, contributing to the drop in manufacturing activity and May’s sluggish employment report. And although oil prices spiked earlier in the year, they have ebbed downward since late April.

Fed officials have made clear in speeches and in the minutes of their last policy meeting that there is a high bar for any new easing measures.

The last bond-buying program was driven partly by concern over low inflation. Last summer, prices were rising at about a 1 percent annual rate, below the Fed’s 2 percent target. Inflation is now at or even a bit above where the Fed wants it to be.

But some Fed officials are skeptical that more monetary easing would do much to raise employment levels. Trillions of dollars sitting on the balance sheets of banks and private firms, and interest rates are near all-time lows, suggesting that a lack of cash is not what’s hurting the U.S. economy.

However, the Fed will be evaluating over the coming months how and when to tighten the money supply, such as by raising interest rates or shrinking the size of its $2.8 trillion balance sheet. The bleaker economic picture will delay such action longer than was expected.

For example, the Fed reinvests the proceeds of mortgage securities it holds when they mature. At some point, the central bank will stop the reinvestment, allowing its holdings to shrink over time. Some analysts had forecast that the Fed would begin that process in the second half of the year, but the economic setback could push that decision into 2012.

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