...More recently, in his press conference, Bernanke expressed confidence that QE2 had in fact worked. Will the evolution of activity this year cause him to reassess his confidence? Might he conclude that QE2 was not particularly effective? We know he already thought the tradeoffs for additional easing were less favorable than last fall, thus he set the bar high for additional action. If he comes to believe that policy was not effective, that bar obviously only goes higher. Complicating this story is the possibility the Fed may worry that another round of quantitative easing will only push investors back into ... riskier assets...
The interplay between market participants, commodities prices, and Fed policy looks quite complicated, fitting with Bernanke's concern that "one risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions."
So where are we now? Watching and waiting. At this point, there seems to be reluctance on the part of Federal Reserve officials to extend the large scale asset purchases. Putting aside the possibility that the events in Europe turn even more ugly, I don't think they will seriously consider such a move until 2012 forecasts begin to deteriorate. For now, watch carefully for Fedspeak that speaks to the forecast â€" whether or not officials continue to see the current challenges as temporary. And look for concern that additional asset purchases would have no impact... We are caught between rhetoric and reality - while the Fed may believe no more is coming, the history of this cycle is that more easing has always been needed.Tim's point about changes in the forecast is trying to get at whether the Fed sees the recent indications of weakness in the economy as a bump in the road, in which case it will soon pass, or a longer lasting problem that may require more Fed action. His second point is that even if the Fed concludes that more needs to be done, if the Fed is convinced it has squeezed nearly all of the economic gains out of quantitative easing already -- that more would do little good relative to the risks -- then the Fed still unlikely to provide more monetary stimulus.
So look for indications in the speech about (1) whether the recent weakness in the economy is long-term or short-term, and (2) if it's long-term, whether the Fed has enough ammunition left to do something about it.
Let me add that I'll also be looking for indications about (3) whether the Fed views the unemployment problem as mostly cyclical or mostly structural. If the Fed thinks it's structural, then there's not much it can do about it in any case. But if the unemployment problem is mostly cyclical, as I believe it is, then the Fed can potentially help.
Finally, (4) how worried is the Fed about inflation? The quoted remarks above about "lacking much experience with this option" indicate considerable uneasiness already, and this post at the blog at the NY Fed hints at emerging inflation worries. What signals will Bernanke give about these worries? Is he still confident the Fed can prevent inflation?
I don't think QE3 is just around the corner, and I think it's unlikely it will come at all. The Fed is uneasy with the size of its balance sheet already, and it is anxious to begin reversing QE1 and QE2. But with the recent weakness, the more probably course is that the Fed will consider delaying the contraction its balance sheet necessary to reverse both QE1 and QE2. Prior to the present weakness, I thought the process of selling financial assets off the Fed's balance sheet would begin this summer followed by potential rate increases very late in the year. I now think it will be later than that, but how much later? I'll look for any indications of (5) when the will Fed begin to contract its balance sheet, and (6) when the Fed will begin raising rates. I doubt we'll hear anything specific, but there may be hints the Fed is leaning in one direction or the other.
Update: See also Ten Questions I Wish Bernanke Would Answer by David Beckworth.