Fed's Lockhart opens the door to QE3

Atlanta Fed President Dennis Lockhart opened the door to the possibility the Federal Reserve may authorize a new round of bond purchases amid worries that the spike in oil and gasoline prices could damage the expanding economy.

Lockhart believes economic activity is accelerating somewhat, and he was quick to point out that his first inclination is to be very cautious about extending asset purchases after June. But given the emergence of new risks he prefers "a posture of flexibility as regards policy options."

Lockhart doesn't believe that crude priced at $105 will stifle the recovery.  And I believe he is correct, as the 30 cent jump in gasoline prices over the past couple of week, though a psychological blow, seems unlikely to threaten the recovery.

The cost to consumers would run about $30 billion over a year, but that's a drop in the bucket when compared to a $14 trillion economy. Moreover, if consumers believe the spike is temporary, macroeconomic theory implies they'll dig into savings to fund discretionary purchases.  

Lockhart, however, becomes less certain if crude jumps past $150 per barrel, which in his view, could force the Fed to implement another round of bond purchases.

Still, unlike the broad increase we saw in energy prices during the last decade, outside of oil, prices have been well behaved, especially natural gas, which has been holding at relatively low levels.  

Lockhart not overly worried about inflation
Currently, Lockhart does not view inflation as much of a threat.  He believes core inflation has bottomed and is drifting higher, and recognizes the importance of keeping the inflation genie locked up in the bottle.

But he noted that business contacts, who were unable to boost prices last year, are planning to pass along some of their higher costs this year.  That's no big surprise given the latest anecdotal evidence seen in the Beige Book.

Still, he feels demand is too fragile to absorb anything other than small price hikes. And measures of longer-term inflation expectations seem to bear this out.   

Treasury Inflation-Protected Securities (TIPS) market show that longer-term inflation expectations are holding steady, while the yield on the ten-year Treasury bond has been in the neighborhood of 3.50%.  

If investors were worried that a wave of prices increases was set to rock the economy, you'd see much higher yields.

Surging oil prices
If crude were to rocket higher in response to escalating Middle Eastern violence, I see two potential scenarios.  Sharply higher gasoline prices brought on by a supply shock that's analogous to what happened in the 1970s could unanchor inflation expectations.  Throw in a round of money printing and bond buys, and the Fed could easily sow the seeds of a new round of crippling inflation. 

Also possible, surging gasoline prices could crimp demand and stifle economic activity, which the Fed would try to offset by QE3.

QE2 has helped to ignite the latest round of commodity inflation as a quick view of the ThomsonReuters/Jefferies CRB Index reveals. 

But QE2 has not been without benefits, as stocks have also been the recipient on new Fed money, which is bolstering the economic outlook. 

Still, the marginal benefits of new buys is likely to decrease, potentially putting the Fed in a position where further stimulus does little to aid economic activity.