The Fed’s summer of discontent

Updated: Jun 02, 2011 2:37 PM UTC

QE2 is almost over. Our long economic nightmare? Not so much.

That's one reason for Wednesday's market rout. Stocks tumbled more than 2% and the yield on the 10-year Treasury note closed below 3% for the first time in six months. Yes, the euro crisis is unnerving, and there are more and more signs around the globe lately that growth doesn't come free.


But there's a bigger problem: It is starting to sink in that the U.S. economy simply is carrying too much debt, and consumers making too little money, for a robust recovery to take root any time soon. Weak economic numbers, ranging from soft jobs gains to signs of a manufacturing slowdown, say the Federal Reserve failed to move the needle with its soon-to-be-completed eight-month course of easier money -- known in financial circles as QE2 for quantitative easing, second edition.

The Fed can hardly shoulder all the blame, of course. But the latest growth downgrade leaves an uneasy truce in which investors and workers await the opportunities afforded by a recovery, without any reason to believe they are coming any time soon.

"People are starting to see that this sort of malaise is not just going to go away no matter what you do," says Andrew Barber, a strategist at Waverly Advisors in Corning, N.Y. "It's looking like the Fed's summer of discontent."

For now, that means a few torpid months watching the nuts in Congress try to blow up the country with stupid posturing over the debt ceiling. With any luck, neither that mess nor the Greek disaster will end in catastrophe.

But while we're keeping our eyes peeled for those wrecks, there is every reason to believe the economy will sag further. The recent slowdown in employment growth and durable goods orders, for instance, left economists at Goldman Sachs "somewhat puzzled" and dubious that a pickup is in sight.

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That leads to the question of whether the Fed, in spite of its desire to stop getting beat up by Congress, will end up pushing a third round of monetary stimulus. The answer, much to Ben Bernanke's chagrin, is almost surely yes.

Bernanke has spent recent months trying to suggest otherwise, though skeptics note that he has stopped well short of actually saying no.

"The trade-offs are getting less attractive at this point," Bernanke said at his April press conference when asked if the Fed would consider a third round of bond buying. "Inflation has gotten higher, inflation expectations are a bit higher, it is not clear we can get substantial improvements in payrolls without some additional inflation risks."

That view got support Wednesday from Pimco's Mohamed El-Erian, who contends that $600 billion of Fed Treasury purchases since November have made QE3 a long shot by "lowering the potential gains and increasing the probability of collateral damage and adverse unintended consequences."

And Bernanke and El-Erian are surely correct that right now, the costs and benefits look stacked in favor of Fed restraint. With unemployment having dropped to 9% in April from 9.8% a year earlier and the press full of stories about $4 gas, inflation now looks very much like the bigger dragon to slay.

But who's to say that will still be true come the end of 2011? It was only in November 2010, after all, that Bernanke was rolling out the second round of quantitative easing, in hopes of reversing what policymakers viewed as a worrisome decline in inflation. As he noted in speech after speech last fall, consumer price inflation by various measures was less than 1% in the year leading up to the beginning of QE2 -- a condition that in his view clearly made monetary expansion a gamble worth taking.

A related measure, the inflation expectations indicated by the spread between 10-year nominal and inflation-adjusted Treasury securities, bottomed out last summer just before the Fed started talking up QE2, at around 1.5% (see chart, right). That figure climbed to 2.6% in this spring's oil spike but has been falling again lately, recently registering just 2.2%.

If inflation expectations keep sliding or hold steady and unemployment stays where it is -- not an outlandish prediction by any stretch -- those numbers will end 2011 right about where they started it. Bernanke will have won a round with the inflation hawks, not that they will ever admit it-- but he also will have nothing to show for all the political capital he risked on behalf of QE2.

This unpleasant round trip and Bernanke's acute appreciation of central banking mistakes of the past are why the Fed will risk another round of political mudslinging to try to prop up the economy again. No one, after all, wants to be the guy who sat idly by as the economy slips into recession in a replay of 1937, however many stories about $5 gas that decision ultimately results in.

In any case, Bernanke may well be the top student of the Great Depression. But as we are learning the hard way, the teacher still has a few tricks up his sleeve.