The biggest weapon that the Fed have is QE. With 1.8% GDP in Q3 2011 and strong economic data in Q4, the worry of a double dip has faded and a third round of QE had been put on the side lines for now. The risk of deflation seems far off with inflation (PCE deflator) at 2.5% in November, well above the 1.5% - 2% range of the FOMC’s projections published in November.
However, unemployment is still uncomfortably high despite a further decline to 8.5% in December, well above the FOMC’s longer term projections of 5% - 6%. Operation Twist is due to end in June and the US may start to feel the impact of an economic slowdown from abroad, these should both add to the downward momentum in inflation. The housing market remains depressed and house prices are still one third below their April 2006 peak. Fiscal policy options are limited due to the warfare on Capitol Hill and the urgency of bringing public finances into order.
I believe that during the course of 2012, QE3 may start to look like more of an attractive monetary policy option for the FOMC to embark on, especially if it is more purchasing of MBS instead of Treasuries alone, this would show that some effort is being put into boosting the housing market. In the Fed’s last meeting it stated that 3 Fed presidents voted against zero interest rate policy. This tells us that the days of easy money from the Fed are over. I think that it would take something bad to happen before the Fed decided on QE3, such as the US data to retreat it latest gains or a market crash i.e. S&P below 1,000.
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