Market debates Fed's next move as QE2 ends

By Steven C. Johnson

NEW YORK (Reuters) - The Federal Reserve ended its $600 billion bond-buying program, known as QE2, on Thursday and has yet to offer any hints of more monetary easing to come.

That hasn't stopped investors from wondering what new tricks the central bank may have up its sleeve should the U.S. economy continue to struggle in the second half of 2011.

Bill Gross, manager of PIMCO, the world's largest bond fund, said last week the Fed may signal as soon as August that it stands ready to print more money if the economy worsens and recession starts looking like a real possibility.

"I'm surprised at how quickly talk has turned to QE3. It began even before QE2 had ended," said Gregory Whiteley, who manages the government debt portfolio at DoubleLine Capital, a Los Angeles-based fund with some $12 billion in assets.

"But it's a bit like automakers who offer incentives to buy. People get hooked on them, and before one program ends, they're thinking about when the next one will come along."

Not everyone thinks the Fed will act so quickly. Including QE2, the central bank's unprecedented policies in recent years have pumped $2.3 trillion into the financial system.

And after a recent run of weak economic data, Fed Chairman Ben Bernanke said "a little bit of time to see what happens would be useful" before taking more policy decisions.

St. Louis Federal Reserve President James Bullard said on Thursday it could take up to a year to determine what effect QE2 has had on the U.S. economy.

In a Reuters poll of 24 fixed-income strategists this month, the median probability of QE3 was 20 percent. A poll of 46 economists in May had even longer odds -- 15 percent.

But timing for the Fed has not been ideal. The end of QE2 comes just as the U.S. economy is losing steam. Growth slowed sharply in the first quarter and data has yet to signal a quick recovery. The jobless rate remains above 9 percent.

That could force the Fed "to get more imaginative," said Quincy Krosby, investment strategist at Prudential Financial, with $859 billion in assets. "Part of the Fed's mandate is to support full employment, so they will have to stay involved."

GRADING QE2

How the Fed would do that depends largely on whether one thinks QE2 and all its side effects were worth the trouble.

The policy was launched late last year to keep a U.S. economy that had just endured the worst recession since World War II from relapsing.

The risks at the time were real. Recovery had stalled, prices were falling, the jobless rate was rising and stocks had gone into a multi-month swoon.

"QE2 was an extraordinary policy tool designed to stave off deflation and it has clearly worked," said Alan Wilde, who helps manage $50 billion at Baring Asset Management in London.

"I'm surprised central bankers have not tried to take more credit for getting some inflation back into the system. They should be shouting this from the rooftops."

But while all that cheap money sparked a stock market rally -- the benchmark S&P 500 is up some 25 percent since August 26, 2010, the day before Bernanke hinted QE2 was coming -- it also helped boost oil prices, which hurt consumers and did little to encourage job growth or revive a moribund housing market.

It weakened the dollar, which makes U.S. exports cheaper and theoretically helps growth. But that has stoked inflation abroad and, some say, threatens to raise U.S. prices as well.

"We truly hope there will be no QE3," Chile's finance minister, Felipe Larrain, told Reuters.

Chile and other fast-growing emerging economies have struggled to cope with massive inflows of inflationary foreign money, a phenomenon many blamed on the Fed's policies.

Greg Michalowski, chief currency analyst at FXDD, said the mixed results should make the Fed think twice about a repeat performance.

"I think maybe one of the reasons why they're not doing QE3 is because, well, you know, (QE2) didn't work." he said. "Oil prices went up. Money went into speculative things. It (hasn't) gone to lending."

'NUCLEAR OPTION'

Wilde said he thinks "QE3 is still a long shot," but added that persistent below-trend growth or rising unemployment mean "a further round (of easing) cannot be ruled out completely."

One method could be what BofA-Merrill Lynch economist Ethan Harris terms "the nuclear option:" buying enough Treasuries to cap yields at a certain level to stoke growth.

The idea seems extreme but has garnered attention. Gross said last week that the Fed could do this by purchasing as many two- or three-year Treasuries as it takes to cap rates.

Back in 2002, before he was Fed chairman, Bernanke also staked out that ground, saying a Fed facing deflation could announce explicit ceilings for Treasury yields.

Harris said this could prove more effective than QE2 because it would amount to an open-ended commitment to buy as many Treasuries as it takes.

"I do think they have ammunition left," he said. "If we start to slide quickly toward recession and the unemployment rate steadily goes up, they can act."

But DoubleLine's Whiteley said speculators would challenge and ultimately break the Fed's resolve. "It's like trying to defend a currency -- market forces push it to the limit and the central bank often relents."

He also said yields could fall anyway once the Fed ends QE2 and private buyers pick up the slack. With growth slow, he said the 10-year yield at 2.50 percent is not inconceivable.

STRONG GROWTH CURES ALL

Of course, if the economy regains its footing, talk of QE3 will fade just as quickly, analysts say.

For one thing, higher inflation may tie the Fed's hands. Core consumer prices, which strip out food and energy, rose 1.5 percent in the year to May. That's not alarmingly high but it is near 2 percent, the top of the Fed comfort zone, and well above a frighteningly low 0.6 percent in October.

Oil prices have also eased to around $95 a barrel after hitting a 2-1/2-year peak near $115 in May..

On Thursday, data showed business activity in the U.S. Midwest grew more than expected in June. That may signal that manufacturing may be regaining traction after struggling in the first half.

What's more, the Fed will probably remain the biggest Treasury buyer as it reinvests principal payments from the government and mortgage debt it owns.

More than $110 billion of Treasuries held on the Fed's balance sheet are set to mature in the next 12 months, and analysts predict it could reinvest up to $190 billion from maturing mortgage-backed bonds over that time. With deflation no longer a clear and present danger, that may be enough.

Even if it falls short, Harris said, the Fed will disappoint those investors who expect the central bank to rush in immediately and protect them from big losses.

"People may think there's a 'Bernanke put' out there," he said, referring to the put options used by traders to protect against price declines. "But they are not going to like the strike price."

(Additional reporting by Ashley Lau, Burton Frierson; Editing by Dan Grebler, Kenneth Barry and Andrew Hay)