Will oil force the Fed’s hand?

NEW YORK (CNNMoney) — William McChesney Martin, Jr., the Federal Reserve chairman during the 1950s and 1960s, famously joked that it’s the job of the central bank to “take away the punch bowl just when the party is getting started.”

He was referring to a need for the Fed to start raising interest rates when the economy was improving in order to make sure inflation and asset bubbles don’t become bigger problems down the road.

But current Fed chair Ben Bernanke doesn’t seem to follow that maxim. Instead, it might be soon time to wonder if the Fed risks leaving the punch bowl out so long that all the guests at the party wind up falling over dead drunk due to alcohol poisoning.

The Fed has already taken a lot of heat from some critics for keeping interest rates near zero for over two years now and also injecting more liquidity into the financial markets with two rounds of so-called quantitative easing.

The Fed launched its latest asset buying program, known as QE2, late last year. The central bank committed to purchase $600 billion’s worth of Treasury bonds by the end of this spring.

Supporters of the Fed would point out that its easy money policies have helped nurse the economy back to a steady, if not spectacular, rate of growth. Low rates, combined with QE and QE2, may also be a big reason behind strong corporate profits and a roaring bull market that’s about to hit its second birthday.

However, the recent spike in crude prices to about $100 a barrel and resulting stock sell-off in the wake of the turmoil in Libya reminded many of how fragile the recovery still is. It even has some wondering if more monetary stimulus is needed to ensure that the economy doesn’t suffer from an oil-induced shock.

James Bullard, president of the St. Louis Fed, said “never say never” in response to a question about whether even more bond purchases, i.e. QE3, may be needed following a speech he gave last week.

But is QE3 necessary? More importantly, would it do more harm than good? Some economists worry that the Fed could create inflation, or at the very least fan the flames of it, with another dose of bond purchases.

The Fed’s stated intention of quantitative easing is to keep long-term rates low in order to stimulate the economy. But low rates could also mean a weaker greenback — and higher prices for commodities that are traded in dollars.

Still, New York Fed president William Dudley defended QE2 in a speech Monday, arguing that the central bank’s bond purchases are not responsible for the big run up in the price of oil and other commodities in the past few months.

That’s partially true. The Fed, of course, has no role in what’s going on in the Middle East and Northern Africa. (Stop those crazy Illuminati-like conspiracy theories now, Fed haters!) But Fed members would be naive to think that the lower interest rate environment they are fostering has no impact on commodity prices.

“It’s clear that there are potential negative implications for the economy merely due to the expectation of future inflation from more easing. It could become a self-fulfilling prophecy,” said Kurt Karl, chief U.S. economist with Swiss Re in New York.

Karl does not think that QE3 is likely. He said that the Fed would need to feel substantially less confident about the economy by the time QE2 is set to expire in June to justify more bond purchases. He added that worries about oil prices may fade in the coming months as the Middle East political tensions play out.

Jeffrey Cleveland, senior economist with Payden & Rygel in Los Angeles, agreed. He pointed out that as long as the unemployment rate continues to drop (it’s fallen from 9.8% in November to 9% in January) the Fed should not need to pull the trigger on more quantitative easing.

However, both Karl and Cleveland said oil is a wild card. The Fed is less likely to view rising oil prices as a sign of inflation and more as a tax on consumers that could curtail spending and economic growth.

So if the problems in the Middle East grow worse and send energy prices significantly higher, the Fed may feel a need to counteract that with more easing.

But Cleveland said he’s not sure that more bond buying will help all that much. He argues that QE and QE2 have been a boon to Wall Street, but not to Main Street.

“The impact of quantitative easing is primarily on the financial markets and not on the real economy. Bank lending is still depressed,” he said. “We’ve been skeptics about the effectiveness of QE2 and that same skepticism would apply to QE3.”

Sooner or later, the Fed will have to take away that proverbial punch bowl. Karl said that barring any economic shocks from oil, the Fed should act more quickly.

He even hinted that rate hikes could be in the cards and that as long as they are gradual, the economy should be able to absorb them without a problem.

“The timing and pace will be key,” Karl said. “Rates are so low to begin with. Moving from 0 to 1% may seem like a big move but a 1% rate would still be accommodative to growth.”

Well put. Getting inebriated on quantitative easing for the past two years may have been fun for our 401(k) portfolios, but the hangover (i.e. inflation) could be a big problem if the Fed bellies up to the bar for a third round of QE.

— The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney, and Abbott Laboratories, La Monica does not own positions in any individual stocks.