Federal Reserve Could be Laying the Groundwork for QE3

There has been a fair amount of speculation lately that the Federal Reserve could engage in a third round of quantitative easing (QE3) sometime in the first quarter of 2012.  That this easing could come in the form of further purchases of mortgage-backed securities is of particular importance to those of us in the mortgage industry, as this action from the Fed would likely drive rates to new record lows.

Chicago Fed President Charles Evans gave a speech at Ball State on December 5, and within it he detailed some of the actions that the Fed could take to support its dual mandate of promoting maximum employment and fostering price stability. Although Evans did not specifically mention asset purchases, he said that without action the Fed could fail both parts of its dual mandate.

While unemployment recently fell to 8.6%, this figure is still very high (and the drop in the unemployment rate can be attributed more to discouraged workers falling out of the work force than to job creation).  Evans termed job growth “disappointing”.  As to price stability, Evans says that Fed forecasts for inflation are between 1.5-2 percent for 2012-2014, which could fall short of the Fed’s goal of 2% growth.

Although U.S. economic data has been somewhat better of late, Evans commented that “even with slightly firmer economic data that have come out recently, the sense of building momentum seems absent.  Rather the headwinds facing consumers and businesses are even stronger than we had thought”.

The Fed President noted that the economic “outlook has weakened substantially” and that “without new developments or changes in policy, I don’t believe the U.S. economy is poised to achieve escape velocity anytime soon”.

To this end, Evans notes that the Fed could communicate that it will keep the fed funds rate at its current exceptionally low levels until unemployment falls to its natural rate.  The caveat is that the Fed needs to be able to rein in accommodation if it sees inflation rising above target levels.  Interestingly, Evans argues that the targeted inflation rate should be around 3%, not the traditional 2% target. Evans argues that higher levels of inflation should be tolerated because of the severity of the economic crisis.

Evans ends by saying that “there is simply too much at stake for us to be excessively complacent while the economy is in such dire shape.  It is imperative to undertake action now”.

I am of the belief that the Fed will engage in further easing assuming that inflation stays under control.  The U.S. economy has a lot of exposure to the Euro-debt crisis, and I think that situation will get worse before it gets better. The economy is not strong, and the Euro contagion could easily drive us into a renewed recession.  We will have to keep an eye on the news and the numbers, but I anticipate more easing and lower mortgage rates by the springtime.