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BEING STREET SMART

by Sy Harding

Is the Fed Sorry It Promised QE2? October 22, 2010.  

The Fed has had stocks and gold spiking up since early September, and the dollar plunging, first on hints that it might consider providing another round of ‘quantitative easing’ if the economic recovery continued to worsen, and then practically promising it’s ready to do so.

It was a complete turnaround from earlier in the year, when it was saying the recovery was coming along nicely and it was time to begin removing some of last year’s stimulus programs, to prevent the economy from overheating and causing inflation.  

As late as June its statement after its FOMC meeting said, “The recovery is proceeding and the labor market is improving gradually. Household spending is increasing.”

Even in its statement after its August meeting, while it worried that, “The pace of the recovery in output and employment has slowed in recent months,” it didn’t seem too worried, saying, “Nonetheless the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”

Meanwhile, in all of its FOMC statements this year it had included the assurance that, “The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.”

When the stock market plunged in its worst August in years, and economic reports worsened further, analysts began asking what ‘policy tools’ the Fed was referring to, since it had already lowered interest rates to near zero, and when the new tools might be employed.

The response was that if necessary the Fed could engage in another round of ‘quantitative easing’ similar to the program it initiated to help pull the economy out of the 2007-2009 recession.

And as markets responded positively to that news, and economic reports continued to worsen, the Fed increasingly hinted it could be ready to pursue such a policy change soon.

Quantitative easing involves buying large quantities of Treasury bonds, with two goals in mind. The first goal is to force long-term interest rates down and perhaps encourage borrowing and spending on big-ticket items by consumers and businesses. The second goal is to lower the interest savers earn on cash and low-risk investments, enticing them into riskier investments in commodities and stocks, thus creating a higher level of inflation that would help ‘inflate’ the economy out of its slowdown.

Since it also involves ‘printing’ more dollars to provide the Fed with the wherewithal to make the large additional bond purchases, it also drives the value of the dollar down. That also helps the economy by making U.S. products less expensive in foreign countries, while making imports into the U.S. more expensive for U.S. consumers, hopefully encouraging more domestic buying of U.S. products.

One downside is that it would significantly increase the massive amount of financial assets already on the Fed’s balance sheet from the first round of quantitative easing in 2008 and 2009, making it all the more difficult for the economy down the road when the Fed has to begin unloading those assets from its books.

It also risks runaway inflation if further easing is not needed but is provided anyway, such as if the economy is going to resume its recovery on its own.

It seems that the Fed no sooner practically assured markets in recent weeks that it will be announcing another round of quantitative easing (QE2) at its November 3^rd meeting, than economic reports began improving. Retail sales surprised on the upside, manufacturing has shown signs of picking up, unemployment claims have declined, leading economic indicators were up 0.3% in September for the third straight month, and 3^rd quarter earnings reports are including a number of improved outlooks from major corporations.

So, it may be that the Fed was correct during the summer in expecting the economy to slow but not into recession, and then begin to strengthen again.

In which case the Fed may now be wishing it had never mentioned quantitative easing, and particularly that it has almost guaranteed markets that it will provide it.

There were some hints this week that the Fed is at least backing away from the size of any quantitative easing program, which some had previously estimated might amount to more than $1 trillion - and perhaps even backing away from the timing of it.

For instance, perhaps preparing markets for disappointment, St Louis Fed President Bullard said on Thursday that, “No decisions have been made . . . . . If we do decide to go ahead with quantitative easing we could think in increments of about $100 billion . . . and then I think we could give forward guidance at each successive FOMC meeting that would suggest how likely the committee thinks it is that it will continue these purchases.”

Markets this week that have factored in a substantial easing program seemed to wonder if they might be disappointed. Gold tumbled more than $40 an ounce. For the first time since the bottom fell out for the dollar again in early September, it closed up for the week. And even the hot stock market rally ran into unusual up and down volatility, seemingly uncertain about what to expect. 

Sy Harding is president of Asset Management Research Corp, and editor of www.StreetSmartReport.com, and the free daily market blog, www.streetsmartpost.com.

These reports reflect our opinions and are based on our best judgment, but no warranty is given or implied as to their accuracy. Past performance does not guarantee future performance.

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