Once again the US economy is flagging as the European debt crisis and the pronounced slowdown in the BRIC economies hamper a sluggish recovery now into its third year. The Federal Reserve must now decide whether to again dig deep into its monetary toolbox in an attempt to goose the economy one more time, or sit tight.
What a difference a few months make. Last spring the US economy seemed strong enough for some economists to advocate a temporary halt to the Federal Reserve’s loose monetary policies. Now, an anemic labor market and the deepening euro zone crisis are reigniting concerns over the strength of the US recovery, leading some observers to call for more — not less — monetary action by the Fed.
The May jobs report, which showed the US economy added a disappointing 69,000 jobs during the month, did little to boost confidence in the recovery. Even more worrying was the sharp downward revision in the April jobs numbers, which revealed employers created only 77,000 jobs and not the 115,000 originally announced. In a blunt assessment of the jobs data, Credit Suisse US Economist Jay Feldman said: “The last two months look awful.”
The bleak economic environment has led a number of regional central bankers and even a Fed vice chairman to hint at the possibility of further monetary easing. Fed Vice Chairman Janet Yellen told a Boston audience that she anticipated the economic headwinds would “continue to restrain the pace of the recovery.” This reality, she explained, called for “further policy accommodation.”
Other monetary doves include John Williams, the president of the San Francisco Federal Reserve, and, like Yellen, a voting member of the policy-making Federal Open Market Committee (FOMC). Williams said recently that the Fed “must… stand ready to do even more… to best achieve our statutory goals of maximum employment and price stability.” Boston Fed President Eric Rosengren agrees, arguing monetary stimulus is “both appropriate and necessary.” Charles Evans, the president of the Chicago Federal Reserve and a non-voting member of the FOMC, has also jumped on the pro-stimulus bandwagon. Evans wants to use monetary policy to speed up the recovery, telling Bloomberg Television: “I’m sure that we’ll get the unemployment rate below seven percent — the question is when. If we had more aggressive monetary policy, it would happen sooner.”
If the Fed decides on further monetary stimulus at its upcoming June meeting, it has a number of options on the table. It could keep interest rates low by extending its $400 billion Operation Twist, a market operation designed to lower long-term rates. The Fed does this by selling medium-term bonds and using the proceeds to buy longer-term bonds. It could also shore up liquidity by initiating a third installment of its quantitative easing program, otherwise known as QE3. Unlike Twist, quantitative easing enables the Fed to grow its balance sheet by actively buying an assortment of short and long-term bonds. Despite the minor differences between the two programs, both share a common goal: Keeping interest rates low.
If the Fed decides not to put its balance sheet to work by either launching a quantitative easing program or extending Operation Twist, a third option is to send a signal to markets by publicly reaffirming its commitment to keep interest rates low until 2014, as it did with a communiqué following its April meeting.
Credit Suisse Chief Economist Neal Soss believes the Fed will take some type of action. “We would expect the Fed to ratify the market’s expectations at the June FOMC meeting, potentially with an innovative or surprising form of expansion or an adjustment to their balance sheet,” he wrote in a recent research note.
While monetary doves see the poor economic data as confirmation that the US needs a liquidity injection, monetary hawks remain cool to more Fed action. Saint Louis Fed President James Bullard, who has pressed for a temporary halt to the Fed’s monetary stimulus for months, said the economic outlook for 2012 — despite the poor jobs report — “had not changed significantly” and did not merit further action. Like Bullard, Sandra Pianalto, the president of the Cleveland Federal Reserve and a voting member of the FOMC, is also not quite ready to pull the trigger on further easing. At issue for Pianalto and some of her colleagues is the impact added monetary action would have on inflation.
For his part, Fed Chairman Ben Bernanke has approached the economic recovery with caution from the beginning. Even when the economy was adding jobs at a healthier clip, he was unwilling to rule out future action by the central bank. Given the current economic situation, Bernanke is unlikely to relinquish the option of unleashing the Fed’s monetary firepower. At least that’s what he indicated in his most recent testimony to Congress in which he reiterated the Fed’s willingness to prop up the economy with added liquidity. “As always, the Federal Reserve remains prepared to take action as needed to protect the US financial system and economy in the event that financial stresses escalate,” he said.
Some economists, however, wonder how much effect future Fed actions would have on the economy. After all, the purpose of quantitative easing and Operation Twist are to keep interest rates low, make money cheap and boost consumption. With nominal rates already at historic lows it’s hard to assess what further easing could do. Faced with this reality of diminishing returns and a market that seems eager for action, the Fed may have little choice but to use words to influence the markets. Any public statement by the Fed carries a lot of weight and it could prove to be a very effective tool in convincing investors that cheap money is here to stay — at least through 2014.