Comstock Partners, Inc.June 23, 2011
Why Fed Policy Is Paralyzed
Here's all you need to know about the current paralysis of Fed monetary policy. The FOMC is officially forecasting an unemployment rate of 7.8%-to-8.2% by the end of 2012----3 ½ years into the "recovery"---and has decided it cannot do anything about it.
The Fed has used all of the conventional tools in its toolbox as well as some that aren't so conventional. It has kept interest rates near zero for an extended period and bought over $2 trillion in mortgages, ballooning its balance sheet to $2.8 trillion from some $800 billion in December 2007. It has also had massive help from fiscal policy including TARP, the stimulus program and numerous other policy initiatives. Despite this herculean effort the economic recovery has been by far the slowest since the great depression, and even that rate has recently diminished to a point where the Fed had to reduce its GDP growth estimates not only for 2011, but 2012 as well.
The Fed's ability to ease monetary policy any further is severely limited. Interest rates obviously cannot be reduced. The second round of quantitative easing will end as scheduled on June 30th and the Fed will not renew it---at least not anytime soon. Compared to last year when QE2 began, the rate of inflation has moved a bit higher and the imminent threat of deflation has receded. They will, however, keep reinvesting the principal of maturing securities in order to maintain the current balance sheet. Since the balance sheet will not be reduced, the end of QE2 is not generally regarded as a tightening of policy. It is well to keep in mind, however, that the average $3.8 billion that the program pumped into the economy every day will come to sudden halt. Therefore, although the end of QE2 is not an "official" tightening it may well have a similar effect.
There are a number of other reasons the Fed is so reluctant to expand its balance sheet at this time. At the current level of $2.8 trillion, any further increase would make it that much harder to undo. In addition QE2 has produced some undesirable side effects such as soaring commodity prices and unwanted inflationary capital inflows to a number of emerging nations. A QE3 could easily exacerbate these trends, more than offsetting whatever beneficial effects it might produce. Any significant balance sheet increase could also run into heavy opposition from elements of Congress that want to restrict or even eliminate the Fed. While theoretically independent, the Fed is certainly subject to outside political pressures and seeks to maintain its current degree of independence.
Chairman Bernanke, at his press conference, also mentioned some other things the Fed could do including extending the period of zero interest rates even further, putting an interest rate ceiling on Treasury bonds or buying more Treasuries or mortgages. We doubt that promising a more extended period of low rates is much different than current policy, while an interest rate ceiling or buying more bonds would both entail increasing the Fed's balance sheet.
That is not to say that a QE3 program is completely off the table. It just appears at this point that the bar for doing it is so high that a prerequisite would be a collapse in the economy and a declining stock market. That would be far too late to help the stock market at its current level.