Economists see slim odds for more Fed help

June 23, 2011 - 6:14 AM

NEW YORK (AP) — Welcome back to investing without a safety net.

There are just seven days left in the Federal Reserve's second round of quantitative easing, the Fed's effort to push billions of dollars into financial markets and prod the recovery forward.

But the $600 billion bond-buying spree, dubbed QE2, ends in the midst of a slowing economic recovery and worries about a European debt crisis. Unemployment remains stubbornly high, factory orders have slowed and gas prices have put a strain on consumer spending. Greece's debt troubles threaten to spread to other countries. And the stock market has given up two-thirds of the gains made earlier this year.

So will these troubles lead to a third round of bond buying? After all, QE2 has helped keep interest rates low and drive investors into stocks, setting off a rally that lasted until the end of April.

The Federal Reserve and its chairman Ben Bernanke have all but ruled out another round of bond buying. And in a recent Associated Press survey, 36 of 38 economists opposed any further effort by the Fed to spur growth. Many say QE3 could stoke higher inflation and provoke a political backlash. What's more, the central bank has already bought $2.8 trillion in mortgage and Treasury bonds and kept short-term interest rates near zero since 2008. Eventually, all those bonds will have to be sold back to the market.

"What would the Fed do for an encore?" asks Jeff Kleintop, chief market strategist at LPL Financial.

So why the whispers among investing bloggers, television pundits and doomsayer Nouriel Roubini that QE3 is a real possibility?

Call it a big misunderstanding. When Bernanke outlined the plan for QE2 last August, the S&P 500 was down 6 percent for the year. In the eight months that followed, the S&P 500 gained 28 percent. Bernanke himself has repeatedly pointed to the stock market's rise as a sign that quantitative easing worked. That's led some investors and pundits to believe that if stocks fall too far, the Fed will swoop in again. Citigroup analysts earlier this month said many traders seem to expect just that.

This view of the Fed as a stock market savior misinterprets the central bank's role.

The Fed has just two jobs. One is to prevent prices from rising or falling too fast. The other is to promote maximum employment. The central bank's main tool for plying its trade: interest rates. It raises rates to fight inflation and lowers them when prices are falling and unemployment seems high.

The idea behind the second round of quantitative easing was simple. Buying Treasurys would make borrowing cheaper and drive investors and banks out of low-yielding bonds and into other investments, like stocks. That, in turn, would create the sort of wealth effect that spurs spending, allowing companies to lift prices and start hiring again.

In the first few months after QE2 launched, that's exactly what happened. Stocks soared. Bond yields rose as investors sold them to the Fed. Americans started spending again and the unemployment rate began to decline. Prices, which had been in a long slide, began climbing. Then, starting in early May, dour economic reports began pointing to a slowdown. The stock market rally hit a wall.

That's when the chatter about a QE3 as a way to boost markets began.

"If you're banking on the Fed to bail you out (as an investor), you're set up for disaster," says Joe Saluzzi, co-head of equity trading at Themis Trading. "That's not the Fed's role."

Economists, including Bernanke, say another bond-buying program could stoke higher inflation. Most importantly, the economy still looks much better than when the Fed launched QE2 last summer.

"Nobody is talking about deflation as they were back then," says Anthony Chan, chief economist at JPMorgan's private wealth unit and a former Fed staffer. "Nobody is talking about a recession. QE3 just isn't on the table."

Still, it could be a rough ride for markets after QE2 ends. Stocks may continue to edge lower until there's solid evidence of economic growth, like a sharp drop in unemployment. On Wednesday, Bernanke said he expected the pace of hiring to be painfully slow.

What's more, trading is usually thin in the summer months, Saluzzi says. That makes it more likely that a wildcard event, such as Greece defaulting on its debts, could cause another steep sell-off.

"You're going to have a rough summer, that's for sure," he says.

Most economists believe that only the threat of falling prices and, to a lesser extent, many more months of weak hiring, would lead to another round of quantitative easing. Right now prices are on a steady climb, even with the recent dip in the cost of gas. The Consumer Price Index is now rising at a 3.6 percent annual pace, compared with 1.1 percent last summer. So-called core prices, which exclude food and energy, grew at a 1.5 percent annual rate in May. That's the highest rate since October 2008. Core prices bottomed out at a 0.6 percent annual rate last October, the lowest figure on record.

Chan, the JP Morgan economist, says the full benefits from the central bank's bond-buying have yet to be seen.

"We're not really done with QE2 yet," Chan says. Even after it spends the last of its $600 billion on Treasurys this month, the Fed will continue to invest the cash it gets from bonds coming due every month. And with the Fed keeping all the bonds it bought, the low borrowing rates available to banks may prod them to free up more cash for small business lending and other loans.

"The Fed can support growth without lifting a finger," Chan says.