The Federal Reserve is ready to ease monetary policy further if economic growth and inflation slow much more, Chairman Ben Bernanke said on Wednesday, giving a boost to the bruised stock market.
While holding to a view that recent economic softness would eventually pass, he appeared less confident in that projection and more willing to entertain the possibility of another round of stimulus.
The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might re-emerge, implying a need for additional policy support, Bernanke told the House of Representatives Financial Services Committee.
The Fed launched an unprecedented round of bond-buying in late 2009 to try to boost the economy and make credit more available, spending some $1.7 trillion on mortgage-backed securities and Treasuries before it ended in March 2010. Later in the year it initiated a second round that wrapped up in June this year in which $600 billion of bonds were bought.
Still, the economy remains in a soft recovery.
Bernanke specifically noted the Fed's forecasts in June, already revised down significantly from April, had not incorporated recent data, particularly last Friday's dismal employment report. It showed job growth essentially ground to a halt in May and June while the jobless rate rose to 9.2 percent.
Hopes for further monetary support sent U.S. stocks, which have taken a drubbing over the last week on worries about Europe's debt troubles and a soft U.S. economy, 1 percent higher, while Treasury bond prices and the dollar tumbled.
The market wasn't thinking there would be any mention of QE3 whatsoever and here we're finding out QE3 is not being ruled out. It's a tantalizing headline, said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi.
Asked whether the Fed would be willing to launch another bond purchase program if the economy slumps, Bernanke said: We have to keep all the options on the table. We don't know where the economy is going to go.
Embarking on a path of further stimulus would not be simple. The second, $600 billion bond buying program, which ended in June, raised eyebrows both at home and abroad when it was first announced back in November.
At least one Fed official, Dallas Fed Bank President Richard Fisher, on Wednesday served noticed that he would oppose any such idea because, he said, the economy already has ample liquidity and adding more might not spur activity.
I will not support further monetary accommodation, Fisher told reporters after a speech in Dallas. There's so much liquidity out there, what's the trigger to put it to work? said Fisher, a voter on the U.S. central bank's policy-setting committee.
Republicans and some economists accused the Fed of laying the groundwork for future inflation, while leaders in emerging economies accused the Fed of a backdoor dollar devaluation.
Pressed on the budget, Bernanke reiterated his warning that a failure to raise the debt ceiling would deal a severe blow to the global economic recovery.
Cutting programs or raising taxes in ways that will reduce aggregate demand ... is going to slow the economy, he said.
Minutes from the Fed's June meeting, released on Tuesday, showed some policymakers believe the Fed should stand ready to provide more support to the economy if the recovery flags, rekindling the threat of a debilitating downward spiral in prices and wages.
Others on the policy-setting Federal Open Market Committee, however, felt inflation risks might force the central bank to withdraw stimulus sooner than is currently anticipated.
DOOR OPEN TO QE3
Still, given the change in tune, some investors were betting the more dovish members of the committee would win the day in pushing for a third round of quantitative easing if the economy continues to deteriorate.
My initial reaction was 'QE3 here we come', said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. We suspected the Fed would come up with some sort of QE3 in light of the disturbance surrounding the sovereign debt markets.
Bernanke did not go into great detail regarding Europe, but the Fed chief's outlook on U.S. growth prospects was understandably cautious.
After recovering from the steepest recession in generations beginning in the summer of 2009, the U.S. economy has lost momentum in recent months. Gross domestic product expanded just 1.9 percent in the first three months of the year, and the second quarter does not look to have been much better.
Bernanke held to the view that recent weakness was due in part to temporary factors like energy costs and the effects on global industry from Japan's earthquake and tsunami.
But he acknowledged the labor market remains weaker than the Fed would like.
The most recent data attest to the continuing weakness of the labor market, Bernanke said.
Bernanke defended the second round of bond buys against critics who said it had been ineffective.
He said the Fed estimates round two of quantitative easing, or QE2, lowered long-term interest rates by between 0.1 and 0.3 percentage point, which Bernanke said would be roughly equivalent to a 0.40 to 1.20 percentage point decline in the federal funds rate, which is currently set in a range between zero and 0.25 percent.
Regarding inflation, Bernanke reiterated the recent rise in prices was mostly linked to transitory factors such as higher energy and commodity prices, and should trend back down.