For QE3 to materialize, the U.S. economy must undergo “a meaningful rise in the unemployment rate or flat unemployment coupled with a sharp fall in co

For QE3 to materialize, the U.S. economy must undergo “a meaningful rise in the unemployment rate or flat unemployment coupled with a sharp fall in core inflation and inflation expectations,” according to Goldman Sachs chief U.S. economist Jan Hatzius.

In a recent report, the Goldman Sachs economist presented his thoughts on the potential for QE3, in light of the substantial wave of disappointing U.S. economic data of late.

“Sure enough, markets that not long ago were predicting rate hikes are now starting to debate QE3,” Hatzius wrote. “But we believe that the Fed’s ‘zone of inactivity’ is much wider than these wild swings might suggest. The hurdle for rate hikes is high, and we feel good about our long-standing view that the funds rate will remain at its current near-zero level until 2013.”

“But the hurdle for QE3 is also high, and indeed much higher than it was for QE2. First, the perceived cost of QE3 is higher because inflation has accelerated. This reflects the fact that at least some of the weakness in growth this year is due to higher commodity prices, i.e. akin to a supply shock. Second, the perceived benefit from QE3 is lower.”

“Fed officials viewed QE1—defined as the overall balance sheet extension that started in late 2008 and ended in early 2010—as a resounding success, and that was probably one reason why they were fairly quick to climb aboard QE2. But they are much less confident that QE2 made a big difference; while it probably did help financial conditions ease and the economy grow a bit more quickly than it otherwise would have done, it’s hard to argue that the effect was large. That has to color their expectations for what QE3 might deliver.”

“And third, the backlash against QE2 both domestically and abroad was greater than Fed officials had anticipated, and they are not keen to subject themselves to another round of similar criticism.”