Will the Fed Opt For More Stimulus as the Economic Recovery Founders?

Weaker-than-expected job growth is fueling speculation that the Federal Open Market Committee (FOMC) will unveil new stimulus measures to prop up the economic recovery when it meets today (Tuesday) for its regular rate-setting session.

Friday's July unemployment report was by most measures a disaster, providing the latest indication the economic recovery is running out of steam with 14.6 million Americans still searching for work.

The economy shed 131,000 jobs, as 143,000 temporary census workers fell off federal payrolls. Private-sector employment grew by 71,000 in July after a downwardly revised June increase of 31,000 workers.

The private sector so far this year has added 90,000 jobs a month on average, well below the 125,000 needed to keep up with population growth - let alone recover the eight million jobs lost during the recession.

"It's a double whammy because it causes people to take a psychological step back," Tig Gilliam, chief executive of staffing firm Adecco Group North America, told The Wall Street Journal. "Now, it looks like not only has the economy slowed, but maybe it wasn't as good when it was originally reported as we thought."

Federal Reserve Chairman Ben Bernanke and his colleagues have begun to consider additional stimulus as the recovery loses momentum. Growth in U.S. gross domestic product (GDP) slowed to an annual pace of 2.4% in the second quarter, down from 3.7% in the first three months of the year and 5% in the fourth quarter of 2009.

The economic outlook is "unusually uncertain," Bernanke said during a July 21 hearing before Congress, even as he forecast "continued moderate growth."

Fed officials may discuss whether to take a small step towards quantitative easing by reinvesting proceeds from its portfolio of mortgage-backed securities to support the economy. The weak jobs numbers buttress the case to take action, though the central bank wants to avoid creating expectations for bigger things to come in the future.

"The hot idea is that the Fed will do another round of quantitative easing," Ralph Shive, a South Bend, Indiana-based manager of the $1.5 billion Wasatch-1st Source Income Equity Fund, told Bloomberg News.

"It's good for equities because it pumps more money into the system if they buy back mortgage-backed securities and Treasuries. On the other the hand, if they do it they also acknowledge the deep hole we're in," he said.

The government has exhausted traditional measures to get the economy growing more briskly, having already cut interest rates to near zero and committed more than $800 billion in stimulus spending.

With conventional tools off the table, policymakers may have to be especially creative to recharge the economy if the already weak recovery continues to slow.

Bernanke told the Senate Banking Committee in July that U.S. monetary policy "is already quite stimulative," while defining three additional strategies the central bank could employ if needed.

The Fed could reiterate its stance to keep short-term rates "exceptionally low" for an "extended period." It could lower the quarter percentage-point interest rate it pays commercial banks for reserves they hold at the Fed. Or it could alter its balance sheet through more quantitative easing.

Money Morning Contributing Writer Jon Markman thinks President Barack Obama's administration might move unilaterally by channeling more money to the housing market via government-controlled Fannie Mae (NYSE: FNMA) and Freddie Mac (OTC: FMCC).

"Specifically, word has it that Obama could order the lenders to forgive a portion of the mortgage debt owed by citizens whose mortgages are larger than the depressed value of their homes," Markman wrote in yesterday's issue. "If the administration were to try to pull this off, it would obviously be very popular with people facing foreclosure, and as a massive new stimulus package would goose the stock market. However it could be a big negative for mortgage bond holders, as they might be the ones forced to take a haircut."

But a resurgent stock market has other analysts believing that the government should leave well enough alone and refrain from further stimulus measures.

"I don't know where the stock market is going, but I will say this, that if it continues hotter, this will do more to stimulate the economy than anything we've been talking about today or anything anybody else was talking about," former Fed Chairman Alan Greenspan said on NBC's Aug. 1 "Meet the Press" television program.

Investors have ignored the poor economic numbers and pushed the Standard & Poor's 500 Index up by 10.2% from its July 2 bottom, giving the central bank some room to maneuver.

"The Fed is looking with gratitude at the easing of financial-market conditions," Lyle Gramley, a former central-bank governor who is now a senior economic adviser in Washington for Potomac Research Group told Bloomberg.

"It is certainly not eager to jump into a big rescue operation for the economy," he said.

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