This spring, the Federal Reserve is going to find itself in a pickle. It must decide whether to administer another dose monetary stimulus to the U.S. economy this summer, or end its intervention with the current round of quantitative easing set to end in June ("QE2"). Even if it wants to continue to stimulate the economy, a combination of economic factors might prevent it from doing so. In particular, it won't be able to lean as heavily on a few of its trusty crutches to assert that the recovery depends on pushing more money into the financial system.
New York Fed President William Dudley articulated why the Fed may want to roll out a third round of quantitative easing ("QE3") in a recent speech, as reported by the Wall Street Journal's Jon Hilsenrath:
"Economic conditions have improved in the past year. Yet the recovery is still tenuous," Mr. Dudley said in a speech in Puerto Rico. "And we are still far from the mark with regard to the Fed's dual mandate. In particular, the unemployment rate is much too high."
That dual mandate, of course, is to work for maximum unemployment and stable prices. In June, it's fairly likely that the unemployment rate will not have deviated much from its 8.8% rate in March. That's still far too high, as Dudley says. But the government numbers have shown pretty significant progress since November, when unemployment was 9.8%. If modest job growth continues through June, and the rate continues to tick down, will the Fed really be able to convincingly say that the economy needs additional monetary support to continue on its slow, but seemingly steady, course?
The other item of its dual mandate may pose an even bigger obstacle to justifying additional stimulus. As most Americans know, food and energy prices have risen substantially this year. Academic economists will tell you that these trends are irrelevant to monetary policy concerns, as they just represent relative price increases. But try telling that to the average American who relies heavily on food and energy as an everyday part of their expenses.
Back when the last round of quantitative easing began in early November, commodity prices were not climbing. At that time, the Fed could say that inflation was a little too low, and few people would question its assertion. If it says the same thing now, however, Americans may not be as complacent. Public perception won't necessarily prevent the Fed from using this argument, but recently the central bank has taken measures to improve its public image. So the anger that could erupt over its attempt to push inflation higher might be a consideration.
There's also a practical concern here. If the economy runs into trouble over the next few months, chances are fairly likely that will be due in large part to the rising food and energy prices crushing consumer sentiment and eating into the discretionary income that could be spent to stimulate the economy. Again, can the Fed really inflate prices if they're the very cause of the economy's struggle?
Another factor might be on the Fed's mind when considering another round of quantitative easing beyond employment and prices. Its mandate also says the Fed must provide "moderate long-term interest rates." Its QE2 has consisted of purchasing longer-term Treasuries since November, which has accounted for about 70% of the demand for those bonds. This has played a significant part in keeping longer-term interest rates low, as stocks have been relatively attractive to investors over this period.
Some have worried that when the Fed stops buying Treasuries, investors might not be eager to soak up all of the supply it leaves behind. Of course, everyone has their price, which means that interest rates might have to rise in order to sell all of the government debt that must be issued. But Daniel Kruger from Bloomberg reports that foreign investors will be eager to increase their Treasury buying when the Fed's effort ends:
"Foreign investors are going to continue to come to the U.S.," said Robert Tipp, the chief investment strategist for fixed income at Newark, New Jersey-based Prudential Investment Management, which oversees more than $200 billion in bonds. "The liquidity aspect is not to be underestimated. If past is prologue, cessation of large scale asset purchases is likely to prove bullish" for longer-maturity Treasuries, he said.
Although this might look like good news for the Fed, if it wants to conduct another round of quantitative easing, then strong foreign investor desire for Treasuries will serve as another roadblock. If demand is very weak for these securities once the Fed stops buying, then it could use the problem as as another reason why it must continue to intervene. After all, it must prevent longer-term interest rates from rising dramatically. According to this Bloomberg article, however, demand for Treasuries won't be an issue.
Add all this up, and you can see that the Fed will have a pretty difficult time justifying another round of quantitative easing. Even if it feels that there is need for more monetary stimulus, economic trends, public outrage, and market conditions might preclude QE3. If the Fed takes off the training wheels, will the U.S. economy be able to ride on its own?
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