By Steven K. Beckner

NEW YORK (MNI) – A third round of “quantitative easing” is not
something Federal Reserve policymakers are eager to undertake, but the
odds of QE3 could increase considerably to the extent that Europe’s debt
crisis reintensifies and threatens to worsen U.S. financial conditions
and undermine economic growth, officials say.

The Fed has been watching anxiously as political rebellion against
austerity in Greece and elsewhere has aggravated European financial
strains and heightened speculation about an eventual crack-up of
Europe’s single-currency system.

The Fed’s policymaking Federal Open Market Committee bases its
monetary stance primarily on domestic considerations, but officials say
a negative, external shock large enough to impinge on U.S. growth, jobs
and inflation could sway the FOMC to provide additional stimulus.

There is no question that the FOMC would once again aid the
European Central Bank if banks in the euro zone again face severe dollar
liquidity pressures. But Fed action could go beyond that into injecting
additional monetary stimulus if financial problems in Europe threaten a
still struggling U.S. expansion, the officials say.

It would take more than a European financial crisis by itself to
induce the FOMC to launch QE3, however. Policymakers would also need to
see a combination of slower growth, disappointing employment numbers and
confirmation that inflation is subsiding as the FOMC has been
predicting.

If European spillover effects get no worse, then they may play only
a marginal role in monetary policy deliberations. But if the situation
were to worsen significantly, it could tip the balance in favor of QE3
if the aforementioned growth, job and inflation conditions also
prevailed.

On Monday, as financial market turmoil crossed the Atlantic to
continue a two-week decline in stock prices and drive bond yields lower,
Fed officials reached by MNI were saying that they could foresee
circumstances in which the FOMC might have to respond not just with
liquidity measures but with further quantitative easing.

David Altig, director of research for the Atlanta Fed, told MNI
Monday that the European crisis is already dimming U.S. growth prospects
and said that if it further damages the economy while also increasing
deflation risks, it could contribute to the launching of QE3.

Another senior official, who did not wish to be identified, was
even more emphatic in saying that the European mess could necessitate
QE3, depending on how the domestic economic picture evolves.

Others are known to hold similar views, although some did not want
to be quoted.

Even before the most recent untoward electoral and market
developments in Greece, Spain, France and Germany, the FOMC was growing
more concerned about Europe.

In its April 25 statement, the FOMC said “strains in global
financial markets continue to pose significant downside risks to the
economic outlook.” By contrast, the March 13 statement had said “strains
in global financial markets have eased, though they continue to pose
significant downside risks to the economic outlook.”

In his April 25 post-FOMC press conference, Fed Chairman Ben
Bernanke acknowledged that “we’ve seen more market stress arising from
concerns about the fiscal positions of Spain and Italy” and “more market
volatility in our own markets.” He added, “A portion of the improvement
that we saw late last year and early this year in European financial
markets and in our own financial markets has been reversed recently.”

Bernanke conceded that “the Europeans have made substantial
progress overall,” and he cited the enlargement of the European Central
Bank’s two large long-term refinancing operations, the Greek debt deal,
work on a European fiscal compact and the enlargement of the euro zone
bail-out fund. But he added, “judging by market conditions, there’s
still more work to be done.”

Since then, Fed officials fears have mounted as the situation in
Europe has deteriorated. Greek voters rejected the austerity measures,
thereby threatening the underpinnings of the carefully structured debt
restructuring deal and raising the odds of a Greek exit from the euro
zone. French and then German election results cast doubt on the
coalition that has enforced fiscal consolidation on the continent.
Meanwhile, debt financing costs for Spain, Italy and others have soared.

Fed policymakers, in public and private comments, have said the
European financial mess, if it continues to worsen, could influence the
Fed to provide additional monetary stimulus if domestic forces point in
the same direction.

Even reputedly “dovish” Philadelphia Federal Reserve Bank President
Charles Plosser said the FOMC “would have to react” to a “financial
implosion” in Europe when asked what it would take for him to support
QE3 on May 3.

San Francisco Federal Reserve Bank President John Williams, warned
of a “real panic” in Europe the same day. He rejected the analogy of
European governments “kicking the can down the road” and instead likened
their problems to a snowball rolling down a mountainside, getting larger
and larger.

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** MNI New York Bureau: 212-669-6430 **

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