How can the Fed reassure markets?

The Federal Reserve's rate-making body will certainly promise Tuesday to keep rates low. It may hint at another program to boost the economy, but don't look for a blockbuster move.

By Charley Blaine Aug 8, 2011 8:50PM

The Federal Reserve has to pull off a fabulous trick when its Federal Open Market Committee meets on Tuesday.

The FOMC, the central bank's rate-setting body, has to tell the badly freaked financial markets that it won't sit still while stocks and the economy fall apart. And it has to calm the bond vigilantes who are sure that anything the central bank does is inflationary.

And, so far as anyone knows, the Fed has to do all that in the form of a written statement due to be released at 2:15 p.m. ET.

That's no easy task.

The Fed could say it plans a new round of purchases of Treasury securities to boost the economy. That would get the immediate handle of QE3, short for a third round of quantitative easing. It finished its $600 billion QE2 program on June 30.

There are economic and political risks to another round of such a program. Still, traders are hoping, The Wall Street Journal noted Monday, especially given the Fed's willingness to help in tight spots over the last 30 years.

Article continues below.

Here's a look at what the Fed may say and may offer to do on Tuesday:

The Fed could say it will do QE3. But the political risks are great, and there are inflation risks to boot. But the question is, as Bloomberg News said Monday, whether a bout of inflation is preferable to a depression.

It may sell off many of its shorter-term securities and buy longer-term notes, a move that would push longer-term rates lower. That's more likely.

It will most certainly communicate its worries. Here's how:

It will acknowledge that the economy has worsened. In its June statement, the Fed said the economic recovery was progressing "somewhat more slowly than the Committee had expected." With recent revisions showing the economy was barely growing at all in the first or second quarters, expect that phrase to be strengthened, Reuters says.

Some of the slowdown was due to the March 11 earthquake in Japan, but higher oil prices, horrible weather and lack of job growth have stalled the economy.

It will have to acknowledge that its economic forecasts are too weak.

It will pointedly say that interest rates aren't going anywhere, maybe for years. The current phrase the Fed has been using for some time is that weak economic conditions "are likely to warrant exceptionally low levels for the federal funds rate for an extended period." That last phrase may be strengthened.

So, did QE2 accomplish anything?

The upside is that the program did give the stock market a huge boost. Between Aug. 27, 2010, when Fed Chairman Ben Bernanke first broached the topic at a Jackson Hole, Wyo., speech, and the market peak on April 29, the Dow Jones industrials ($INDU) jumped 26.2%, with the Standard & Poor's 500 Index ($INX) up 28.1% and the Nasdaq Composite Index ($COMPX) up 33.4%.

The market rout has cut those gains to 6.5%, 5.2% and 9.5%, respectively.

It did help put a floor under manufacturing and allowed the recovery of the domestic auto industry to continue.

The downside, at least according to critics, is that the cheap money set off wild speculation in oil, gold, silver, cotton and commodities. The Fed argues that those commodities were rising anyway. The Fed was only partly responsible.

Crude oil, in fact, more than doubled from $33 a barrel when it bottomed in February 2009 to $72 on the day of the Bernanke speech. Crude peaked at $113.93 on April 29 and started to fall back as gasoline prices cut into consumer spending.

Crude settled at $81.31 on Monday, off 29% from the April peak.

Tags:

BenBernankeCharleyBlaineeconomyFederalReservepoliticsstockstreasurys

< Back to Latest Dispatches