Fed policy: So many risks, so few tools

June 4, 2012

Chris Reese contributed to this post.

A barrage of rotten economic news around the world has suddenly and vigorously reawakened the prospect of additional monetary easing by the Federal Reserve – most notably a report on Friday showing job growth slowed sharply in recent months.

William Larkin, portfolio manager at Cabot Money Management in Salem, Mass., said:

The chance of another recession is on the table, no question about it. It might force the Fed to develop another growth strategy like a QE3.

A Reuters poll of U.S. primary dealers, banks that do business directly with the Fed, showed they now see a 50 percent chance of a third round of quantitative easing, up from around a third before the jobs figures. Even more forcefully, Vincent Reinhart, a former Fed economist now at Morgan Stanley, now sees an 80 percent chance of central bank action at its meeting on June 19-20.

However, Fed officials themselves admit that, given official interest rates are already near zero and its balance sheet remains bloated, there is not very much more the central bank can do to effectively boost economic growth and bring down unemployment. What’s more, the bulk of the Fed’s unconventional policy measures are aimed at keeping down long-term interest rates. But with a raging European crisis instilling new fear in the hearts of bankers, Treasury bond yields have already been plumbing repeated new record lows.

That doesn’t mean the Fed won’t try. Fed Chairman Ben Bernanke has made clear he is a policy activist who would rather err on the side of too much stimulus than see the economy slide into a deeper rut. He could extend a program of selling shorter-term securities and buying longer-dated ones, or even launch a fresh incursion into mortgage bond buys to help spur a housing recovery. Unfortunately for the depression scholar and former Princeton professor, the Fed’s once mighty toolbox is looking increasingly bare.

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