Fed may have bullets left, but are they blanks?


When Federal Reserve Chairman Ben Bernanke takes the podium next week at the central bank’s annual meeting in Jackson Hole, Wyoming, his sense of deja vu may be overwhelming. Stocks have been giving up gains won after last year’s speech, when Bernanke hinted at plans to pump more money into the financial system. Oil prices are higher and there’s been little improvement in the job market.
Bond yields are down, though, because the economic outlook has deteriorated. It’s almost as if QE2, the Fed’s $600 billion bond-buying programme first mentioned at last year’s meeting and designed to boost the struggling economy, never happened. That’s not to say investors doubt the central bank’s resolve to act again if the U.S. economy keeps losing steam. Last week, it surprised markets with an unprecedented pledge to hold interest rates near zero until at least 2013.
But given questions about the efficacy of monetary stimulus to date and a growing political backlash against the Fed’s policies, investors expect the U.S. central bank to keep its powder dry at this year’s Jackson Hole symposium from Aug. 25-27. “The Fed already shocked the world when it indicated its ultra-low interest rate policy would remain in place until 2013,” said Fred Dickson, strategist at D.A. Davidson & Co in Lake Oswego, Oregon. “That telegraphed the economy is going to stay weak. But monetary and fiscal policies haven’t worked very well, so I don’t expect we’ll get a QE3 announcement. That would really catch everybody by surprise.”
It’s not that the central bank doesn’t have a few tricks left up its sleeve. Bernanke has previously detailed what he could do next. This includes buying long-dated Treasuries to push down long-term rates and cutting interest on bank deposits held at the Fed to encourage more lending. Still, there’s the problem of ever diminishing returns. The benchmark S&P 500 index rallied more than 4 percent when the Fed on Aug. 9 said it would keep rates low into 2013, but fell more than 4 percent the next day.
At around 1,200, the index is off its Aug. 8 low but trading remains volatile.
POLITICAL BACKLASH: Then there’s the limited impact the Fed’s quantitative easing, or QE, has had on the broader economy, which ground to a halt in the second quarter and, some fear, is flirting with a slide back into recession. Economists polled by Reuters now expect the economy to grow at just a 1.7 percent rate in 2011, well below the Fed’s June forecasts of 2.7 to 2.9 percent. Including QE2, which ended in June, the Fed has spent some $2.3 trillion in recent years to prevent a slide into deflation, more than tripling its balance sheet in the process. “On one hand, QE2 added to the U.S. market.
On the other, a lot of the liquidity fled and went into emerging markets and commodities, and those commodities, including oil, went higher in price,” said Ashish Shah, head of global credit at AllianceBernstein, with $216 billion in fixed-income assets. “So you actually robbed consumers of purchasing power.”
That has put the Fed in the line of fire of some politicians and voters — so much so that some investors fear the growing politicization of Fed policy could curb its independence. Texas Governor Rick Perry, a Republican candidate for president, even said he would consider it “treasonous” if Bernanke “prints more money between now and the election” in 2012.
William Larkin, fixed income portfolio manager at Cabot Money Management, dismissed Perry’s remarks as “crazy talk,” but did say the Fed faced increased political hurdles. “The Fed is going to face a lot of push back,” he said. “Keeping rates low has caused talk of financial repression —- stealing from savers and giving to debtors.” A weaker dollar, partly the result of the Fed’s easing, also complicates things. While it in theory helps exports, it also makes imported goods more costly, putting more pressure on consumers. Against major currencies, the dollar is 11 percent weaker since the August 2010 Jackson Hole meeting.
“The Fed is being viewed as a political rather than financial actor, so their policy responses may have to be political as well as economic,” said Boris Schlossberg, head of research at GFT Forex. “As they lose their credibility among a certain segment of the population that whittles away the kind of independence they used to have.” Support for more easing isn’t universal within the central bank, either. Dallas Fed President Richard Fisher, one of three policymakers who voted against keeping interest rates low until 2013, blamed “fiscal malfeasance in Washington” for the economy’s woes.