Washington Gridlock Could Push Fed to Act on Economy With QE3

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Published November 23, 2011

| FOXBusiness

Gridlock in Washington is convincing more economists that the Federal Reserve may have to ride to the economy’s rescue once again, perhaps with a new trillion-dollar-plus stimulus effort.

The failure of the Congressional deficit “super committee” this week, the prospect of continued tax, budget and policy standoffs in Washington through the 2012 election, and the pending expiration of several legislated stimulus provisions have increased the likelihood the Fed could soon launch another round so-called “quantitative easing,” to try to push down longer-term interest rates to stimulate economic growth, the economists said.

The Fed executes “QE” with big purchases of government bonds and other securities; it has launched two previous QE rounds totaling about $2 trillion. The Fed has said more QE remains a policy option for stimulating the economy and stronger job creation. The program likely would be designed to push down mortgage rates in particular, to try to jumpstart the struggling housing market.

About $100 billion in payroll tax cuts for workers are scheduled to expire on Dec. 31, as are about $60 billion in unemployment insurance benefits and $50 billion in tax breaks for companies that buy new equipment—in total, more than $200 billion in government assistance, amounting to more than 1% of gross domestic product.

“The numbers are large, so it would be a significant reduction in the support that fiscal measures are providing to the economy,” said Karen Dynan, a former Fed economist who is now the co-director of economic studies at the Brookings Institution in Washington. “Demand will decline, employers will respond with more layoffs or less new hiring, and slack in labor markets will increase.  This will put the Fed yet further away from its (full) employment target and thus is likely to compel more action.”

President Obama has called for extending the expiring provisions through 2012 as part of his $450 billion jobs plan. House Republican leaders have said they are open to considering the moves, though some Republicans want them offset with spending cuts elsewhere in the federal budget so they don’t add to deficits. The Senate is expected to vote next week on extending the payroll tax cut, and maybe more.  

Roberto Perli, another former Fed economist now with ISI Group in Washington, said, “If this doesn’t happen, then the additional 2012 fiscal drag would be one more reason for the Fed to at least think about additional easing moves, and QE would be the obvious choice in that case.”

Joseph Gagnon, a former Fed economist now with the Peterson Institute for International Economics in Washington, believes that sub-par job creation and economic growth – it is running at less than 2% so far this year – makes another round of quantitative easing next year highly likely. The outcome of the negotiations between the White House and Congress on the expiring provisions, he said, will simply determine the size of the program.

“My guess is (that) if by January, they haven't extended (them) or taken some other comparable action, the Fed will almost certainly move,” he said. “If the payroll tax cut is not extended and nothing else is done, then I think you're thinking of more than $1 trillion (in additional bond purchases) -- as much as $2 trillion.”

The Fed’s policy body, the Federal Open Market Committee, meets next in mid-December and then again in late January. The Fed’s previous QE programs, to help the economy in the recent financial crisis and its aftermath, have expanded the Fed’s balance sheet to about $2.8 trillion.

“They would expand their balance sheet (again) and ‘print money’ to buy the assets,” Gagnon said. “They think that what they've done (before) has already had a positive effect.”

Kevin Hassett, a former Fed economist now with the American Enterprise Institute in Washington, said he feels another round of QE is unnecessary because recent economic data “look pretty solid” and “we need to wean ourselves off of the dependence on stimulus. If we do, then the Fed will watch the data and give us QE3 if it turns sour… so QE3 would be maybe a 30% probability.” If the central bank launches it, however, he thinks new securities purchases could total $500 billion to $1 trillion.

Perli and others said the Fed also may be spurred to adopt additional QE or other monetary policy easing because of the debt crisis in Europe, which could also hurt the U.S. economy.

“Losing the payroll tax cut could shave as much as a half percent from GDP which, depending on the recovery in employment, will keep the recovery on very fragile ground,” said Diane Swonk, chief economist at Mesirow Financial in Chicago. “(But) QE3 is not just a tool for a fragile economy, (it is) a weapon in the face of a crisis. Europe could represent that crisis.”

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