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The Federal Reserve has laid out plans to keep interest rates close to zero until 2014, unless the economy and employment were to perk up notably between now and then. But if growth were to slow materially from here, the Fed is considering another round of quantitative easing, or a way to ease monetary policy with rates already as low as they can go. This time, by  "sterilizing" asset purchases, it would potentially be without the feared side effect of inflation. The stock market would likely react positively if the Fed were to take action.

Now that the central bank cannot lower its targeted interest rate any further, it has been increasing its balance sheet as an expansionary monetary policy tool, in a move known as quantitative easing. In August 2007, prior to the financial crisis in the United States, the Federal Reserve had assets and liabilities of around $900 billion.  In contrast, its balance sheet stood at $2.9 trillion at the beginning of March, 2012, or more than three times the pre-crisis size. The Fed has indicated that it is willing to pad its balance sheet further, too, if that is what it takes to generate a self-sustaining economic recovery.

One of the outcomes of the Fed’s zero interest rate policy is that is has pushed investors into riskier assets classes, such as the stock market, and away from holding cash or bonds that don’t generate nearly the income they once did. That has helped fuel the stock market rally, uneven as it may have been, these past few years, creating a wealth effect that supports consumer spending. 

However, a side effect to aggressive monetary policy is often higher inflation. The Fed’s method of paying for the additional assets on its balance sheet, electronically creating reserves in the banking system, boosts the money supply. That, in turn, pressures the value of the U.S. dollar, which tends to push up the prices of gold, oil, and other commodities, including food. These days, people filling up at the gas station or walking down supermarket aisles are shaking their heads at the higher prices. And even if rising food and energy prices are outside the Fed’s so-called core rate of inflation and considered temporary, they can damage the economy while they are in force.

So, what is the Fed’s next move? If the economy were to falter, the central bank stands ready to do more bond buying to shore up business conditions. That would likely provide another boost to the stock market, since Wall Street usually applauds aggressive Fed action, but could also fuel inflation and mean a full-fledged recovery is further down the road. To stave off the inflationary threat, the central bank is looking at borrowing back the money used in the asset purchase transactions using instruments known as reverse repurchase agreements. That sort of financial engineering would theoretically keep the money supply from further expanding. 

If growth does slow, the Fed’s innovative sterilized bond-buying program seems like a way to accomplish two goals at once: boost economic growth and keep the inflation threat subdued. Such a strategy may be put into practice at some point this year, with GDP likely to remain below its long-term trend in the United States, slowing growth in the world’s emerging market nations, and the euro zone already apparently in a mild recession. But the best-case scenario might be if the Federal Reserve didn’t have to do anything for a while, since that would mean business conditions are healing on their own.

At the time of this article, the author did not have positions in any of the companies mentioned.