01/05/2012 06:49 pm ET

Federal Reserve May Try Third Stimulus If Economy Worsens, Experts Say

As the international economic climate becomes more threatening, there is talk that the Federal Reserve could try another monetary stimulus to aid the U.S. economy. Yet questions linger about whether an injection from the Fed would give it the boost required to pull out of its malaise.

Some experts say that the Federal Reserve might buy a large amount of mortgage-backed securities if the U.S. economy does not show any marked signs of improvement or the situation in Europe reaches crisis proportions. The move to buy the private assets, in a third round of so-called quantitative easing, or "QE3" as some call it, would inject money into the financial system, which would result in more loans and added spending by consumers and businesses, leading to higher stock prices followed by even more spending as Americans feel wealthier, according to several economists.

Indeed at the end of last year, the Federal Reserve started dropping hints about another round. Fed Chairman Ben Bernanke suggested the possibility of quantitative easing in November, when he said that "purchases of mortgage-backed securities is a viable option." Janet Yellen, vice chairman of the Fed, also said in November that further quantitative easing was possible. "The scope remains to provide additional accommodation ... through additional purchases of longer-term financial assets," she said in a speech.

"It's a definite possibility but not a sure thing," Donald Kohn, a senior fellow at the Brookings Institution who served as vice chairman of the Federal Reserve between 2006 and 2010, told The Huffington Post on Thursday. "The circumstances where they would want to do more is if the unemployment rate didn't seem to be declining or it was declining very, very slowly while inflation was low."

The Federal Reserve already has embarked on two quantitative easing programs. It purchased $1.25 trillion in mortgage-backed securities and $300 billion in government bonds at the beginning of 2009 in a first round, and it bought $600 billion in Treasury bonds in a second round, which began in November 2010 and ended last June.

Clearly, quantitative easing did not completely revive the economy, yet many praise the strategy. Kohn from Brookings said that the Fed's previous quantitative easing helped people secure loans and boosted the stock market, which stimulated spending. He also noted that it slightly weakened the dollar, which led to more competitive U.S. exports that strengthened U.S. companies and ultimately American spending.

"These programs obviously weren't enough to put the economy on a really strong track, but I think they helped to some extent," Kohn said. "The economy would have been even weaker if they hadn't done those things."

A few critics counter that quantitative easing could cause inflation, create asset price bubbles, weaken the dollar and spark a currency war with other countries.

Talk of more quantitative easing bubbled up at the end of the year. Morgan Stanley predicted in a December research note that the Federal Reserve would buy $500 billion to $750 billion in mortgage-backed securities and Treasury bonds to try to stimulate the economy this year. In addition, 60 percent of banks that do business directly with the Fed said in a December survey that they expect the central bank to start another round of quantitative easing within a year.

Princeton economics professor Alan Blinder, who served as vice chairman of the Federal Reserve from 1994 to 1996, said he believes the Federal Reserve should embark on quantitative easing this year to boost economic growth and bring down the unemployment rate. The Fed should buy $500 billion to $1 trillion in mortgage-backed securities, since "you get much more bang for your buck" by buying private-sector assets rather than Treasury bonds, he said in a phone interview. The Fed's second quantitative easing program was less effective than the first because it focused on Treasury bonds rather than private-sector assets, he added.

"If the economy kind of sails along at its languid pace through 2012, the Fed is not likely to do anything more," Blinder said. But if there is a financial shock from the crisis in Europe or an oil shock from Iran's increasingly aggressive stance toward the West, "it will kick the economy down the staircase again, and I think the Fed would feel compelled to do something more," he said.

"The likelihood that we're going to have some kind of financial eruption stemming from Europe must surely be over 50 percent," Blinder added.

Some Prudential executives said at a conference on Wednesday that they believe that a monetary stimulus is probable this year. The Federal Reserve most likely will pursue quantitative easing sometime between April and June -- during the second quarter -- because unleashing a monetary stimulus any closer to the presidential election could provoke "a lot of political backlash," said John Praveen, managing director and chief investment strategist at Prudential International Investments Advisers.

This year's second quarter would be an ideal time for quantitative easing, Praveen said, because "the European debt crisis will probably deepen or escalate" during the first half of the year.

But Bernanke needs to wait for the economy to get worse in order to help it get better, said Michael Lillard, managing director and chief investment officer at Prudential Fixed Income Management. He said that if economic data does not get worse, the Fed may hold back.

"If you do see weakness in economic growth, you are going to see QE3," Lillard said. "The Fed is certainly at the ready."

As a matter of policy, a Federal Reserve spokeswoman Barbara Hagenbaugh said that the Fed would not comment on future moves. But she did cite the Federal Open Market Committee's Dec. 13 statement: "The committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools to promote a stronger economic recovery in a context of price stability."