By Colin Barr
September 14, 2010

A top economist cooked up a lukewarm case for another round of Fed action.

Goldman Sachs economist Jan Hatzius said in a presentation to investors that the Fed is likely to start buying $1 trillion of so of Treasury bonds later this year or early next year as the economy weakens. He said doing so could add perhaps a third of a percentage point to economic output in the coming year, helping to keep a weak recovery on course as federal stimulus spending eases.

“The meager final demand growth we’ve seen so far has occurred in the context of very substantial support from fiscal policy, and that support is going to start turning into a drag,” Hatzius said. “If you want to tell a story about a double dip recession, this is probably the most straightforward way.”

That said, Hatzius doesn’t expect a double dip recession. He argues that the risk of a double-dip downturn is no greater than about 1 in 3 because the banking system is healing and because industries such as house building and automobiles are already so depressed that they can hardly get much worse.

But he said a weak economy that is already on track to average just 1.5% growth in the second half of 2010 could soften further absent a new round of monetary stimulus.

The market has been expecting since job growth peaked early this summer that the Fed will engage in another round of so-called quantitative easing, in which it expands the size of its balance sheet by buying bonds from banks by creating new money. The Fed bought $1.75 trillion worth of Treasurys and mortgage-related securities starting in March of 2009, at a time when the economy appeared on the brink of free fall.

Hatzius has been saying this summer that more asset purchases are likely because policymakers recognize the danger of a premature tightening of financial conditions. The recovery from the Great Depression was interrupted in 1937 by a decision to tighten credit standards.

The Fed’s first round of asset purchases, carried out over a year, succeeded in easing financial conditions, as measured by the Goldman Sachs Financial Conditions Index, by about 0.8 percentage point.

Hatzius said the next round of asset purchases wouldn’t likely pack the same punch, because it won’t start at a time when the credit markets are “expecting the end of the world.”

Nonetheless, Hatzius said a new round of Fed easing could ease financial conditions by half a percentage point or more, and boost gross domestic product growth by 0.3 to 0.4 percentage point.

He conceded Fed asset purchases would have “a relatively modest impact” on an economy already operating well below capacity and suffering from 9.6% unemployment.

“It  wouldn’t be enough to make the difference in the economic outlook from extremely negative to extremely positive,” Hatzius said.

He also said that the Fed isn’t likely to make any announcements about new easing plans at next week’s scheduled meeting of the Federal Open Market Committee, and that he has changed his mind over the past few months about the approach the Fed might take when it does act.

In the wake of comments this summer by St. Louis Fed President James Bullard and recently retired Fed Vice Chairman Donald Kohn, Hatzius said he now believes a “shock and awe” approach is less likely.

“I now think there is probably more thought given to a more gradualist approach,” he said.

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