January 2012

Unless inflation unexpectedly flares again, a third round of Federal Reserve securities purchases may be in the cards during the first half of 2012 as monetary policymakers fret that a eurozone economic slowdown could undercut U.S. export demand.

"Banks are starting to make loans again, and that's a good sign," says Paul Kasriel, Northern Trust's chief economist. "However, we are going to be hit with a foreign shock — our exports are going to be considerably weaker in 2012. So there might be a role for quantitative easing in 2012 to boost domestic demand even more to compensate for the weaker export growth."

Several members of the Fed's Open Market Committee had opposed more accommodation from the central bank because they are concerned inflation might re-emerge as a result. Thus far, however, that has not been the case.

In fact, late 2011 data confirmed the softening trend in U.S. consumer-level inflation from a spike earlier in the year. "We've seen inflation. Earlier in 2011, there was a spike in commodity prices, which was due mainly to overheating in the developing economies — China, India, Brazil," explains Kasriel. "Commodity prices are cooling off, and U.S. inflation is moderating now."

During the three months ended November 2011, the consumer price index rose only 0.8%, and the core rate (which excludes the volatile food and energy components,) rose at an annualized rate of just 1.4%, far below the pace recorded in the previous three months.

"These numbers suggest that the Fed has latitude to consider a third round of quantitative easing to support the economy, given inflation does not present a threat," adds Asha Bangalore, senior vice president of Economic Research at Northern Trust.

If anything, the numbers leave the door open for more easing because of concerns that declining overseas export demand could offset the pickup in domestic demand that resulted from the second phase of quantitative easing. Growth in U.S. exports shows a significant moderation and could continue to do so as economic growth elsewhere slows.

In fact, Kasriel figures the 27-nation European Union, which collectively represents the world's largest economy, likely entered its own mild recession during the fourth quarter last year. In addition, the deceleration visible in eurozone monetary financial institution credit is an important factor that can prolong the European recession.

So the United States likely will avoid a recession during the next 12 months, assuming continued expansion in bank credit. "However, U.S. growth will not be sufficient to bring down the unemployment rate significantly, which in the context of moderating inflation, could prompt another round of Federal Reserve quantitative easing," Kasriel concludes.