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The Fed Is Laying the Groundwork for Further Easing

This graph of inflation expectations derived from financial assets of various maturities is one of the reasons why I am now starting to think the the Fed may expand its balance sheet further that it has with QE1 and QE2 (the Fed's balance sheet, which was just under a trillion dollars prior to the crisis, has approximately tripled in size, and it would grow even larger if the Fed embarks upon another round of quantitative easing):

[Source]


The graph shows that prior to the crisis inflation expectations were fairly stable at a bit over 2%. However, when the crisis hit, inflationary expectations dropped, and by some measures (those based upon shorter term assets) the expectation turned highly negative.

The Fed is very sensitive to and very fearful of deflation, and the fall in inflation expectations evident in the graph was one of the reasons the Fed decided to implement QE1. And as you can see from the graph, this (along with the other steps the Fed took at that time) turned the expectations around, at least for awhile. However, just before the dotted vertical line on the graph, expectations began falling again. What is the vertical line? It shows the point in time when QE2 was announced by Ben Bernanke (August 27 of 2010 at Jackson Hole, Wyoming), and once again inflation expectations turned around.

However, notice that recently the trend has turned downward again and if this continues the Fed is likely to intervene once again.

In fact, the Fed is beginning to lay the groundwork for this. As the WSJ reports:

Federal Reserve officials are starting to build a case for a new program of buying mortgage-backed securities to boost the ailing economy, though they appear unlikely to move swiftly.
And Federal Reserve governor Dan Tarullo in his speech on Thursday:
I believe we should move back up toward the top of the list of options the large-scale purchase of additional mortgage-backed securities (MBS), something the FOMC first did in November 2008 and then in greater amounts beginning in March 2009...
Finally, in a meeting with members of the Senate on Thursday, Ben Bernanke stressed the need for more action to help housing markets (though he didn't mention it specifically, further purchases of mortgage backed securities would provide more help for to these markets).

It's not a done deal yet. Recent inflation data, which appears to be elevated by temporary factors, has some members of the Fed wary of doing anything that might further increase the risk of inflation. In addition, fears of a double-dip could diminish and bring inflation expectations back up without Fed action. But it does appear the Fed is trying to move in this direction.

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