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Fed QE3 May Hit $1 Trillion as Fiscal Deadlock Persists

The Federal Reserve stands as the only source of policy support for a U.S. economy burdened by 7.9 percent unemployment after the presidential election preserved the balance of power between Democrats and Republicans.

“If you’re going to get stimulus, it’s got to come from the Fed,” said Paul Edelstein, the director of financial economics at IHS Global Insight in Lexington, Massachusetts. “They’re the only game in town.”

A fiscal boost to the economy is probably off the table as President Barack Obama negotiates revenue increases and spending cuts with leaders of a Democratic-controlled Senate and a House of Representatives led by Republicans, Edelstein said. That may leave only the Fed in the position of trying to boost the economy, and its third round of quantitative easing may extend through next year and climb past $1 trillion, said economists at JPMorgan Chase & Co. and Pierpont Securities LLC.

Treasuries rose, pushing 10-year yields down the most in five months, as Obama’s re-election bolstered speculation the central bank will maintain a bond-buying program that San Francisco Fed President John Williams this week said may exceed $600 billion. Republican candidate Mitt Romney had criticized the Fed’s policies and said he’d replace Chairman Ben S. Bernanke, whose second term expires in January 2014.

The 10-year yield fell 10 basis points, or 0.1 percentage point, to 1.65 percent yesterday, according to Bloomberg Bond Trader prices.

Yellen Succession?

Ward McCarthy, chief financial economist at Jefferies & Co. in New York, said it’s “highly probable” that Fed Vice Chairman Janet Yellen would replace Bernanke if he leaves in 2014. “That suggests the era of QE will be extended,” he said, because Yellen has supported the Fed’s record monetary stimulus.

Stocks tumbled as Obama’s re-election set up a showdown with the Republican-controlled House over the budget, with the so-called fiscal cliff of more than $600 billion in tax increases and spending cuts slated to start in January unless Congress acts before then.

The Standard & Poor’s 500 Index (SPX) dropped 2.4 percent, the most since June, to close at 1,394.53 in New York. The retreat wiped out roughly $370 billion in market value from U.S. equities, according to data compiled by Bloomberg.

House Speaker John Boehner of Ohio said yesterday Republicans may accept new tax revenue to cut the budget deficit if it’s accompanied by a tax overhaul and changes to entitlement programs. All sides are “closer than many think” to being able to revise the tax code, he told reporters in Washington.

Electoral Votes

Obama won the White House by capturing at least 303 electoral votes to Romney’s 206. Republicans kept a majority in the House and Democrats retained control of the Senate.

Bernanke said Sept. 13 that “fiscal-policy uncertainty” was already causing companies to hold off on hiring and making investments. “The sooner it can be clarified, it’ll be beneficial not just because we avoid the cliff itself, but because we clarify for firms” how it will be resolved, he said.

Corporate spending on equipment and software was little changed in the third quarter, the weakest in three years. The Institute for Supply Management’s factory index, a proxy for sentiment, was 51.7 in October after 51.5 the prior month. It has hovered above 50 -- the dividing line between expansion and contraction -- after shrinking in June, July and August.

The unemployment rate climbed in October to 7.9 percent from 7.8 percent in September as more people entered the labor force in search of work. Unemployment held above 8 percent for 43 consecutive months through August.

‘Sustained Improvement’

“We’re looking for ongoing, sustained improvement in the labor market,” Bernanke said on Sept. 13, when the Fed announced its open-ended program to buy $40 billion of mortgage debt per month. “There’s not a specific number we have in mind. What we’ve seen in the last six months isn’t it.”

In a statement last month extending the bond-purchase program, the Fed said “growth in employment has been slow.” The economy expanded at a 2 percent annual pace in the third quarter, compared with 4.1 percent at the end of last year.

“It’s going to take a long time for unemployment to come down and growth to really pick up,” Williams told reporters after a speech in Irvine, California on Nov. 5. He said bond purchases should be “at least” $600 billion, “but I would think it would probably be bigger given my view on how slow the economy is going.”

Harder Job

The fiscal cliff makes the Fed’s job that much harder. Gross domestic product would shrink by 0.5 percent next year and joblessness climb to about 9 percent if it isn’t averted, according to the Congressional Budget Office. Bernanke has said he lacks tools strong enough to offset such an impact on growth.

Monetary policy is limited in its capacity to provide additional stimulus,” said Antulio Bomfim, senior managing director at Macroeconomic Advisers LLC in Washington and a former Fed staff economist. The Fed’s benchmark interest rate is already near zero, and for asset purchases, “there’s a limit on how much more they could buy without actually affecting the functioning of the market.”

Bernanke has argued that lawmakers need to address the nation’s fiscal shortfall with a long-term plan while also not acting too quickly to choke off a still-fragile recovery.

“If you had something that actually did that -- that could be both supportive enough of aggregate demand and supportive enough of improved sentiment on the economy -- that could prevent the Fed from needing to do more,” said Michael Feroli, chief U.S. economist at JPMorgan in New York. “But that just doesn’t look realistic right now.”

Extended Horizon

Bernanke has kept interest rates near zero since December 2008, and the Fed in September extended the horizon for record- low rates through at least the middle of 2015.

The Fed bought $2.3 trillion in securities in its previous two rounds of bond-buying and has swapped its short-term Treasuries with longer-term securities in a program called Operation Twist, due to expire in December.

Feroli predicted QE3 will last through the first half of 2014. Mortgage debt purchases may reach $700 billion, and when Operation Twist expires at the end of the year, the Fed will also start buying Treasuries at a similar pace, Feroli said.

Fed officials aren’t “going to stop until they feel pretty comfortable about the economic situation, and I just don’t see us being in an environment that generates strong growth,” said Stephen Stanley, chief economist at Pierpont in Stamford, Connecticut. “I don’t see this great movement toward bipartisan kumbaya coming in January” or “anything coming from the policy side that’s going to push an acceleration in growth.”

To contact the reporters on this story: Caroline Salas Gage in New York at csalas1@bloomberg.net; Jeff Kearns in Washington at jkearns3@bloomberg.net

To contact the editor responsible for this story: Chris Wellisz at cwellisz@bloomberg.net

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