By Peter Schroeder - 06/03/11 10:00 AM EDT
The Federal Reserve is at a crossroads.
With its controversial second round of quantitative easing wrapping up at the end of June but the economic recovery losing momentum, many are wondering what the next move is for the central bank — or if it even has one to make at all.
But the end of the effort is now in sight, and new economic data paint a disheartening picture of the economy.
Economic indicators over the last two weeks have consistently come up short of analysts’ expectations, leading many to worry that the economy is losing steam. That has also given rise to fresh speculation that another bond buyback — dubbed QE3 — could be in the works at the secretive institution.
“Everyone thought a few weeks ago it was impossible to have QE3, and now it becomes a real possibility,” said Axel Merk, president and chief investment officer at Merk Investments.
“I’m sure they’re debating this furiously,” said Phillip Swagel, a professor of economics at the University of Maryland and former Treasury official under President George W. Bush.
Absent a major downturn and a significant threat of deflation, many Fed-watchers are skeptical a third round of easing is in the works, if only because the second round apparently didn’t accomplish much.
“It probably didn’t have a huge positive effect on the economy,” said Swagel. “The upsides to QE3 are very small … the downside is that the Fed could potentially lose its credibility.”
Daniel Alpert, managing director of Westwood Capital LLC, said that while QE2 pumped money into the banking system, it does not appear that money has made its way out into the broader economy.
“It’s like the roach motel of economic policy,” he said. “The money goes in and it never comes out.”
When the Fed embarked on QE2, it was “extremely worried” about deflation, said Karen Dynan, vice president for economic studies at the Brookings Institution and a senior adviser at the Fed until 2009.
At the very least, QE2 helped put those fears to bed, but now growing concern about inflation — driven in part by congressional Republicans — could throw cold water on a third round of bond purchases, she said.
“There’s just so much angst out there. … A lot of this is related to the backlash against QE2,” she said. “That angst opens up this risk that maybe inflation expectations will move up.”
Several lawmakers, mostly Republicans, have been strongly critical of QE2, accusing the Fed of sowing the seeds of damaging inflation or even facilitating government spending by monetizing freshly issued debt.
Doubts about the central bank have also been raised by the Tea Party. One of the movement’s favorite lawmakers, Rep. Ron Paul (R-Texas), now chairs the subcommittee overseeing the central bank. His views on the central bank are expressed succinctly in the title of his book, End the Fed.
Furthermore, the outsized role the Fed took on during the financial crisis — making emergency loans around the world and buying up over $1 trillion in mortgage securities — might have stepped on a few toes in Congress.
“By having veered into that in the financial crisis … they have gone beyond their mandate, and the implication of that is Congress got more involved,” said Merk. “Because Congress doesn’t like it when somebody meddles on their turf.”
The Fed has long billed itself as immune from politics, but the central bank has clearly felt the heat in recent months. The bank tacitly acknowledged the need to respond to public criticism when it announced Bernanke would begin holding regular press conferences with the media — a first for any Fed chairman.
But even if the Fed were to shake of the political pressure and embark on a third round of fiscal intervention, it would first need to figure out how to get out of QE2.
In the most recent minutes of the Federal Open Market Committee (FOMC), it was apparent that exiting from QE2 was a major topic of discussion at the bank’s April meeting.
The Fed went out of its way to make clear that just because officials were talking about exiting from QE2 did not mean it was imminently in the works.
But the minutes paint a portrait of Fed governors grappling with exactly how to handle the winding-down of QE2. On the one hand, the Fed could vary the rate at which it unloads the bonds back onto the market in response to economic conditions, which would grant it flexibility. But on the other, it could set a regular schedule for selling back the bonds, which would be a more consistent policy that is easier to explain to the public and the markets.
Another variable the Fed has to consider is how to use its interest rate-setting powers while reducing its portfolio.
But for the time being, most expect the Fed to do nothing and hold onto its procured assets.
By holding onto the Treasury bonds it has accumulated during QE2 and not selling them back onto the market, the Fed could still offer up accommodative monetary policy while limiting the risk of inflation.
“QE2 is not ending; the liquidity that’s being created remains in the system. The money that’s been printed keeps the banking system awash in money,” said Merk. “In many ways, the Fed has done what it can do … the problems we have are not one of low interest rates; the problem is one of overextended consumers.”
While the economy searches for traction, experts think the Fed is limited in what it can do, as larger structural and fiscal issues weigh down the recovery.
“We’re out of monetary policy alternatives at this point,” said Alpert.
“It’s really not their issue anymore,” said Swagel. “This is an issue for the White House, not the Fed.”