FED FOCUS-Weak economy to prompt Fed QE3? Not so fast

Anemic U.S. growth is not enough to prompt Federal Reserve Chairman Ben Bernanke to call for a new round of monetary stimulus.

A failure to resolve the political deadlock over U.S. debt or a drop in inflation might be.

The economy grew at a bare 0.4 percent annual pace in the first quarter and a still disappointing 1.3 percent in the second, according to data released on Friday.

But Fed officials expect growth to pick up substantially this quarter, and are unlikely to consider a third round of quantitative easing, or QE3, unless that growth does not materialize, their comments suggest.

Even then, as Atlanta Federal Reserve Bank President Dennis Lockhart said on Friday, it's a "very high bar" for further stimulus. For details see [ID:nN1E76S0SJ].

The biggest reason, Fed officials and economists say, is rising inflation.

In the 12 months to end-May, core inflation reached 1.2 percent, by the Fed's favorite measure. While that's not troubling on its face, it marks a sharp acceleration after bottoming out at 0.7 percent in the year to December.

Fed officials believe temporary factors account for some of that surge, but they are watching it closely as they aim to keep inflation over a mid-term horizon from topping 2 percent.

"Before going ahead they want to see clear evidence that the economy really is stuck and that inflation risk is contained," said Anil Kashyap, a professor at the University of Chicago's Booth School of Business.

So far, the evidence is not there.

"Inflation is elevated somewhat right now, so I think the backdrop for doing more stimulus, QE3 or whatever, is different," San Francisco Fed President John Williams said on Thursday.

In his prior job, as the regional Fed bank's research director, Williams was a vocal supporter of QE2, the central bank's second round of bond buying, which ended in June.

But those purchases were launched when officials were worried about deflation risks. With those risks largely banished, the equation has changed.

Officials are also concerned bond buying may generate diminishing returns in terms of its impact on the economy.

"Additional asset purchases is an option, but I think the hurdle there is high," Williams told reporters when asked what the Fed could do if inflation did drop dangerously.

"I think the policies have helped, they have worked, but I think there's a lot of uncertainty about their effects, and so you have to be cautious."

Indeed, the most recent economic data, including the slashing of first-quarter GDP growth on Friday and the recent rise in the U.S. unemployment rate to 9.2 percent, may bolster those, like Richmond Fed Bank President Jeffrey Lacker, who argue the Fed's most recent bond buying did little for the economy. [ID:nN1E76R1GT]

Most economists agree that the Fed's first round of bond purchases, launched when financial markets were in distress, were the most effective.

"I would think it would take some kind of news that GDP is going to be a lot worse than that, and some kind of stress in financial markets that would suggest that asset purchases would be effective," said Mark Gertler, an economics professor at New York University.

"That doesn't seem to be the kind of situation we are in right now. It's not even clear how effective another round of QE would be."

The Fed's last bond-buying program prompted complaints from politicians at home and abroad who said it risked driving down the dollar and sowing the seeds of a troubling inflation.

"If we were in a deflationary environment, Bernanke would say he doesn't care about the criticism and would do whatever it takes," said Eric Stein, an economist at Eaton Vance in Boston. "But where we are today, I think it makes an impact."

Everything could change if lawmakers do not resolve a dispute over raising the nation's $14.3 trillion borrowing limit that has alarmed financial markets with the possibility the U.S. government could default on its debt within weeks.

With the U.S. economy already skating on thin ice, a shock could spark a fresh recession.

Driven by those concerns, traders on Friday pushed out expectations for a Fed rate hike to 2013, from a view yesterday that the Fed would likely move in the fourth quarter of 2012.

"The biggest potential negative shock is the self-inflicted political wound," said Gertler. "Everything is on hold until we know the outcome of that."