Why the Weak Economy Will Lead to More Fed Intervention

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Despite evidence that its previous actions have done little to revive the U.S. economy, the U.S. Federal Reserve is likely to take more action before the end of the year barring a swift turnaround in such indicators as unemployment, consumer spending, and housing.

The Federal Open Market Committee (FOMC) minutes from its Aug. 9 meeting, released on Tuesday, indicated that several members already favor more Fed intervention.

The FOMC discussed virtually every policy tool available to it, including a third round of bond-buying known as quantitative easing (QE3), an "Operation Twist" that involves selling shorter-term notes and using the proceeds to buy longer-term notes, and setting numerical targets for unemployment and inflation.

Some members pushed for immediate action based on worsening economic news such as a second-quarter gross domestic product (GDP) of just 1%, but others doubted that more Fed intervention would help.

"Some participants judged that none of the tools available to the committee would likely do much to promote a faster economic recovery," said the Fed. "Those critics believe that current economic headwinds can lessen only gradually over time, or that recent events had lowered the impact such moves might have."

Critics of the Fed's interventionist policies, engineered by Chairman Ben S. Bernanke, maintain that the previous rounds of quantitative easing, as well as holding interest rates at between 0% and 0.25% have been ineffective, if not harmful.

"Bernanke's first two rounds of quantitative easing had three major consequences: higher inflation, higher unemployment, and higher borrowing costs for average Americans," said Money Morning Global Investing Strategist Martin Hutchinson.

The FOMC reached a compromise at its August meeting – a promise to keep the Fed's key interest rate at historically low levels at least through the middle of 2013. Even that minimal action drew three dissenting votes out of 10.

Recognizing that it would face the same contentious issues – and more pressure to take action – at its next gathering in September, the FOMC agreed to meet for two days instead of just one.

Moving Toward QE3?

This week some individual members of the FOMC have made comments that indicate a gradual shift toward more Fed intervention.

One of the dissenters, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said in a speech that he planned "to abide by the August 2011 commitment in thinking about my own future decision."

Rather than dismiss QE3 out of hand, Kocherlakota simply said that "the case for any additional easing would have to be made on its own merits."

Meanwhile, one of the so-called doves on the FOMC, President of the Federal Reserve Bank of Chicago Charles Evans, was making the case for more Fed intervention.

"We need to do much more to increase the level of accommodation," Evans told the Wall Street Journal.

Citing an unemployment rate hovering above 9%, Evans told CNBC that he would support "some of the most aggressive policy actions" available to the Fed, including QE3.

Some Fed observers say that another wave of lousy economic reports this month will push even the recalcitrant members of the FOMC to consider further intervention more seriously – including QE3.

"Despite the internal opposition, easing remains on the Fed's policy table," Michael Gregory, a senior economist at BMO Nesbitt Burns in Toronto, said in an analysis of the Fed minutes. "August turned out to be a horrid month for U.S. economic data."

The minutes of last month's FOMC meeting make it clear most members favor more Fed intervention.

"While all felt that monetary policy could not completely address the various strains on the economy, most members thought that it could contribute importantly to better outcomes in terms of the committee's dual mandate of maximum employment and price stability," the minutes said.

And in his Jackson Hole speech last Friday, Bernanke vowed the Fed would "do all it can to help restore high rates of growth and unemployment."

So more Fed intervention appears nearly inevitable – if not at the FOMC's September meeting, then probably at its November meeting.

"Priority number one is to get the economy rolling again — off three cylinders and hopefully closer to six," Ward McCarthy, chief financial economist at Jefferies Group Inc. (NYSE: JEF), told Yahoo! Finance. "Their primary interest is making sure we get the economy going so we can get unemployment down."

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