Lower Inflation Gives The Fed More Leeway in 2012

The Fed could step in to stimulate the economy in 2012, but will it help?

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The Federal Reserve's de facto role as the crutches for the limping U.S. economy will likely continue into 2012, especially since inflation has cooled off after spiking earlier this year, experts say.

After two consecutive rounds of quantitative easing, some experts were concerned the Fed's bond-buying programs would create too much inflation and damage the fragile economic recovery. Now that consumer prices have leveled off for the time being, the Fed doesn't have to worry about runaway inflation and has more latitude to try to boost the economy as it sees fit.

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That could play out in a couple of ways. One option would be to kick off another round of bond buying to drive long-term interest rates down in the hopes of spurring more borrowing. The other is to communicate an intention to keep rates low even longer, possibly through 2014, which should provide some stability to financial markets, especially corporations looking to fund business investments.

"By doing that they take out the unknown of corporate planning, and that's definitely a plus," says Bob Andres, chief investment officer and strategist at Merion Wealth Partners.

But while it seems the Fed has been the only backstop given the lack of action on the economy with Democrats and Republicans bickering in Washington, neither of the Fed's options to stimulate the economy are great at this point, Andres says. There are too many other factors dampening the recovery, including tight credit and crimped consumer spending.

"In this environment, the Fed has substantially less influence," Andres says. "People look at the Fed as waving a magic wand, but what are they going to do now? Take [rates] down from ¼ [percent] to 8 basis points? That's not going to have any effect."

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And, similar to what happened after the Fed's second round of quantitative easing, another bond-buying program could have unintended effects. "Here's the catch-22: If they come in and do that, it tells you that the economy needs them to do that," Andres says, which could prompt more instability and uncertainty in financial markets. "What has happened in the past is that rates went up."

Still, Andres expects the Fed to do what it can to bolster the economy in early or mid-2012, primarily because the global and domestic economy has shown signs of a slow-down. "I think that the Fed will do QE3. The odds of that are increasing daily," Andres says. "I think they will feel forced to come in early in first quarter or the second quarter."

One complication is the presidential election. Fed members have historically tried to avoid being seen as helping or hurting an incumbent president. Staffers for former president George H.W. Bush blamed former Fed chairman Alan Greenspan for not doing enough to stimulate the economy after the 1990 recession—an act they believed led to Bush's defeat in 1992.


Twitter: @mmhandley