Fed needs time to see how the economy plays out

Is the QE2 about to set sail?

No, I don't mean the retired transatlantic cruise ship. Rather, the "QE2" I'm talking about is the shorthand the Street has adopted for a second wave of quantitative easing from the Federal Reserve Board - something that has surely moved to a front burner after last week's crummy U.S. employment report.

With the Fed's meeting Tuesday for its latest decision on monetary policy, the jobs report was a timely reminder that the U.S. central bank's policy course has become fraught with obstacles: A slowing economy, a pessimistic consumer base, and, perhaps most ominous of all, a re-emergence of deflation fears. The debate over the possible launch of QE2 is growing louder by the day.

BELIEVING THE BONDS

Some observers argue that the economic data, while uniformly rotten for June, have looked more stable for July, save for the job numbers. And those numbers were unreliable, distorted by the evaporation of temporary U.S. census jobs - hardly a strong foundation on which to build an argument for QE2.

But while the economists bicker, the bond market is screaming its fear - specifically, about the rising spectre of deflation. In the past four months, the yield on the U.S. government bond has tumbled from nearly 4 per cent to just 2.8 per cent; the two-year yield is a paltry 0.55 per cent, near a record low and less than half of what it was in April.

The bond market's fears go beyond a handful of disappointing economic reports. Looking at the horizon, investors see that a couple of major inflationary elements in the U.S. economy are turning deflationary.

After spending months - and a lot of money - re-stocking their warehouses, U.S. businesses are likely to slow their inventory build-up precipitously in the coming months. Meanwhile, the massive stimulus spending by the U.S. government, a major positive to U.S. GDP growth since the first half of 2009, will actually become a drag on GDP starting in the current quarter, as those funds dry up.

"The Fed needs private-sector demand to accelerate because the fiscal thrust is now turning deflationary," said Eric Green, head of U.S. rates research and strategy at TD Securities.

HOW WOULD THE MARKETS TAKE IT?

One logical answer is for the Fed to get back into the quantitative-easing business, to flood more cheap cash into the system and keep the economic wheels turning.

If this is done in an orderly way, the move would likely stabilize bond markets, and be cheered by stock markets. It would underpin growth prospects, encourage investment and risk-taking, and lift confidence that the Fed is on top of the deflation threat.

Mr. Green argued that QE2 would likely drive the U.S. dollar down another 10 per cent, but if it has its desired impact - i.e. boosting economic growth - then it shouldn't trigger a sustained downturn in the greenback.

But the key is in that word "orderly" - and that may be the big sticking point in the Fed doing anything in today's policy decision.

The Fed's own economic outlook, up to this point, has not been nearly as bleak as many Wall Street economists have become. If it were to launch a QE program today, it would signal a major about-face in its view. That may do more harm than good, sending fear rippling through the markets.

More likely, then, is that the Fed might tweak the wording of its policy statement or make some small-scale unconventional steps for now, just to show the market that it is willing to reach into its arsenal. That would buy the Fed some time to see how the economy plays out - and prepare the markets for a launch of QE2 later in the year, if necessary.