Colin Barr

Following the money in banking, economics, and Washington

Weak housing strengthens Bernanke's hand

August 24, 2010: 1:08 PM ET

Ben Bernanke's case for another round of Fed easing just got a little easier to make.

Tuesday's home sales plunge is adding to unease about the health of the economy. July house sales were "eye-wateringly weak," Paul Dales of Capital Economics said. "With the increasingly inevitable double-dip in prices yet to come, things could yet get a lot worse."

Easy does it?

Though one poor housing number alone won't change any minds at the Fed, a deepening decline in sentiment could help Bernanke prod reluctant fellow policymakers to back a new round of monetary stimulus. Some economists hail renewed central bank purchases of government bonds as the best bet for a recovery from America's bubble-itis.

"The signs in the U.S. economy are not good," said Roger Farmer, an economist at UCLA who says the central banks in the U.S. and the U.K. should vastly expand their purchases of government debt in a bid to bolster flagging demand for goods and services. "It's important to do things soon."

Bernanke, the Federal Reserve chairman, has argued in the past that a central bank confronting falling prices and weak employment at a time when it has already cut short-term interest rates near zero must take other action to boost economic activity.

Among those policies are Federal Reserve purchases of assets such as government bonds, also known as quantitative easing. But a story in the Wall Street Journal Tuesday shows that many Fed officials remain reluctant to sign off on another go-round, after the Fed sopped up $1.75 trillion in Treasury and mortgage bonds between March 2009 and this past spring.

Skeptics such as Kansas City Fed President Thomas Hoenig contend that easy money policies can't solve the economy's problems, and carry the threat of a new boom-and-bust cycle or a round of high inflation.

On this count, Hoenig's not alone. More than a third of Federal Open Market Committee members have reservations about the Fed resuming asset purchases, the Journal reported.

"Recent comments suggest that the decision to reinvest the proceeds from the Fed's holdings of MBS into Treasuries was a much closer call that it initially looked," Dales said. "That suggests there is little appetite for QE2 right now."

Yet stimulus backers warn that the economy desperately needs more juice at a time when banks aren't lending and asset-backed securities markets have shriveled to a fraction of their former size. The M3 measure of money supply has contracted by 4% over the past year, according to Capital Economics.

"The broad money supply has been falling," Farmer said. He says the Fed must step into that breach to keep the economy from enduring another big contraction. He adds that the Fed's control over the interest rates it pays banks should preclude an inflationary spike when the recovery starts.

Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics in Washington, contends the Fed should use another round of asset purchases to drive interest rates -- already at their lowest levels in decades save for the postmeltdown panic of the winter of 2008-2009 -- down still further. Doing so could boost demand and reduce stubbornly high unemployment, he says.

The argument is hardly airtight, given the weak response of employment to the first round of Fed asset purchases. But with states pulling back on their spending and inflation readings raising fears that prices will fall, Bernanke could find more backers of the strategy St. Louis Fed President James Bullard laid out last month.

"I don't think the house-sales number by itself is enough," said Gagnon. But if "unemployment stays high or core inflation continues to fall, the Fed will act."

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Colin Barr
Colin Barr
Senior Writer, Fortune

Colin Barr has covered finance for Fortune.com since November 2007. Previously he was a writer and editor for TheStreet.com, winning a 2006 Society of American Business Editors and Writers award for "The Five Dumbest Things on Wall Street," and for Dow Jones Newswires. He is a 1991 graduate of Penn State and lives in Port Washington, N.Y., with his wife Meena Bose and their two kids.

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