Sizing up the Fed’s few options

June 8, 2011, 7:39 PM UTC

By Cyrus Sanati, contributor

FORTUNE — Wall Street is abuzz with speculation that the government is gearing up to inject billions of dollars of fresh cash into the economy in an effort to speed up economic growth. It would be the third time since the financial crisis that the government, more specifically the Federal Reserve, would move to grease the wheels of the U.S. economy by essentially printing money.

Ben Bernanke

But with inflation and unemployment ticking up at the same time, the Fed will find it difficult to justify yet another cash injection, known as quantitative easing. Nevertheless, there are some scenarios in which the Fed might vote for more QE, despite the negative side effects that all that cash could have on the economy down the road.

Last week, stock markets around the globe fell following the release of several negative economic indicators, including worse-than-expected job growth. In response, Federal Reserve chairman Ben Bernanke gave what some believe was a signal to the markets that the Fed would move to counter the slowdown by instituting a third round of QE, after the second round, QE2, ends this month.

“The economy is still producing at levels well below its potential; consequently, accommodative monetary policies are still needed,” Bernanke said in a speech in Atlanta on Tuesday. “Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.”

Cryptic as ever, Bernanke held back from saying directly how the Fed would act to support the economy. Many economists, though, believe that the current slowdown isn’t bad enough to induce the Fed to go ahead with QE3. There is even some debate whether all this QE has even made a difference on the economy at all.

Helicopter Ben

But Bernanke has said on several occasions that he has no problem dumping money on the economy to prevent it from locking up. Indeed, the Federal Reserve has moved swiftly throughout the financial crisis to make sure cash was available to banks and other financial institutions. The idea simply is that if the banks have access to cheap cash, they will be more apt to lend it out to businesses and to each other. This lending would trickle down through the economy, boosting business activity and eventually causing unemployment to fall.

One of the negative side effects of this policy is inflation. By injecting cash into the economy, the Fed increases the size of the money pool. That weakens the value of the dollar relative to other currencies, which is bad for that European vacation, but also bad for prices on imported goods and commodities.

At the time the Fed began its second round of quantitative easing, inflation was low, so Bernanke felt comfortable instituting a program that would see $600 billion injected into the economy. After all, how much inflation can $600 billion cause when the country has a national debt load of $14 trillion and a personal debt load of $30 trillion?

Inflation has jumped in the last three months at a much faster pace than historical averages. The consumer price index rose by 6.1% annually during the April quarter, and core CPI, which excludes food and energy, rose by 2%. Such an accelerated move in inflation would be explainable if there was strong economic growth, but that’s not the case.

Bernanke said in his Atlanta speech that inflation was currently not a problem. While that’s true now, the rate of acceleration must be setting off alarm bells at the Fed.
“If you’re Bernanke and you are seeing this rapid acceleration in core inflation and a high unemployment rate, you got to be thinking to yourself, ‘Gee, my models aren’t working right,’” says Drew Matus, senior U.S. economist at UBS Investment Research. “This should cause more caution in the part of the Fed and it is this caution that will keep them from doing QE3.”

But is there a chance that the Fed might act anyway? If unemployment gets bad enough that it zaps out inflation, we’ll probably see “Helicopter Ben” raining money down on Wall Street yet again. The small uptick in unemployment last week from 9% to 9.1%, though, doesn’t seem to justify another $600 billion cash injection like we saw with QE2. Furthermore, most economists are still upbeat about the economy in the second half of the year, with consensus growth at around 3%.

“Our view is that while growth has weakened in the first half of the year, in the second half of the year we will see an improvement in growth,” says Dean Maki, chief U.S. economist at Barclays Capital. “I wouldn’t rule out QE3, but it would require a lack of improvement in the economy in the second half of the year for that to come about.”

Another way the Fed could act would be to vote to extend QE2 as a stopgap measure until it sees growth back on the upswing — let’s call it QE2.5. Here the Fed could approve a small, one-time cash injection. It could vote more mini-QEs at subsequent meeting, if necessary, which could serve as a little boost to the economy while keeping inflation in at a minimum.

The European uncertainty

A full-fledged QE3 program might be in the cards, though, if there is another major lock-up in lending, similar to what occurred in the months before and after the fall of the investment bank Lehman Brothers in September 2008. One possible calamity on the horizon that could tip the Fed’s hand is the ongoing sovereign debt crisis in Europe.

“Basically the Fed will only do another overt round of QE if Europe causes a liquidity crisis, in other words, if Greece defaults,” says Constance L. Hunter, chief economist at Aladdin Capital Holdings. “If there is burden sharing in Europe [in an effort to bail out Greece], I bet that will cause some liquidity issues.”

In such a scenario, the big European banks would stop lending to one another amid fear that they are exposed to the toxic Greek debt. Banks would start to hoard cash and stop lending to the public, dragging the European economy to a halt. Such a scenario would quickly start a contagion, causing U.S. banks to freeze lending as well. If that happens, the Fed will not hesitate in pumping as much money as needed into the economy to make the banks feel comfortable enough to lend again. For now, the European Union and the International Monetary Fund are working hard to avoid such a liquidity crisis from occurring, but there is only so much they can do to head off such an event.

With the economy projected to get over this current soft patch and grow in the second half of the year, the Fed will find it hard to justify further QE. If it does go ahead, it may cause more harm than good. More QE will drive the value of the dollar down and pump up asset prices. Wall Street likes that to some degree, since stocks would likely rally.

Main Street, meanwhile, will have to contend with a subsequent rally in the commodities market, most notably, higher energy prices. And since high energy prices were to blame for much of the slowdown in growth this past quarter, the Fed could be shooting the U.S. economy in the foot if it goes too far with QE3.