The Standard & Poor's 500 Index closed yesterday with a 1.5% gain on speculation that the Fed would at least indicate to investors that it is prepared to take further action to support the economy.
The Fed conducted its last major round of Treasury purchases from January 2009 to March 2010, buying $1.25 trillion in mortgage-backed securities and about $175 billion in debt owed by government agencies. The Fed planned on gradually reducing its balance sheet as the debt matured or was prepaid.
But last month the Fed signaled it might resume its quantitative easing steps when it voted to reinvest the principal payments in longer term Treasury securities. And with little improvement in the U.S. economy since then, analysts think the central bank is preparing to take the next step.
"The Fed's rhetoric will get the markets ready for the real possibility of expanding their balance sheet at a later meeting this year," Richard Clarida, a Columbia University professor and global strategic adviser for PIMCO, said Monday in a Bloomberg radio interview.
Fed bond-buying increases liquidity and lowers yields, forcing investors to turn to riskier asset classes which boosts the credit supply. Buying Treasuries would also put downward pressure on long-term interest rates.
If the Fed decided to start quantitative easing again, it could lower the yield on the benchmark 10-year Treasury note to 2.0% from 2.75%, according to Richard Berner, chief U.S. economist at Morgan Stanley (NYSE: MS).
The Fed could take a "shock-and-awe" strategy of buying $2 trillion worth of securities, doubling the $2.3 trillion already purchased, or it could take a more modest incremental approach.
Former Fed governor Laurence H. Meyer said the more drastic option could raise economic growth by 0.3 percentage point next year and 0.4 percentage point in 2012, but unemployment would stay high at 9.2% in 2011 and 7.7% in 2012.
What the Fed decides will affect the direction of Treasury prices, which rose Monday.
"The short-term price action for Treasuries will be heavily influenced by the FOMC and the wording of the policy statement in regard to the potential for additional QE (quantitative easing) in the foreseeable future," said Ward McCarthy, chief financial economist and managing director of the fixed-income division at Jefferies Group Inc. (NYSE: JEF).
Most analysts expect the Fed to be hesitant to commit trillions to buying Treasuries because the exact effectiveness of such a measure is unclear. It is hard to gauge just how much the previous Treasury purchase program directly affected yields, and even more difficult to judge how much a new program would work amid economic uncertainty.
A dramatic move also could spook investors, push inflation toward dangerous highs and damage Fed credibility.
"My own view is that any radical balance sheet program would be seen by many as an act of desperation which would dampen business sentiment and depress non-financial borrowing even more," Lou Crandall, chief economist at Wrightson ICAP, told Reuters.
Fed chairman Ben S. Bernanke has hinted that he would support additional economic action to prevent deflation. While deflation isn't an immediate concern, the Fed is worried that inflation is only at 2%, or half the desired level, and unemployment is still at 9.6%.
"Given the likelihood that unemployment will remain unacceptably high for the foreseeable future, more quantitative easing is looking more and more like an agenda item for the Fed, whether it actually works to stimulate job growth or not," Neal Soss, chief economist at Credit Suisse Group AG (NYSE ADR: CS), wrote in a report last week.
"There is plenty of pressure on the Fed to put forward what they are going to do to stop the U.S. going into a double-dip recession," said Will Hedden, a sales trader at IG Index. "It will be the main focus of the week and the market could go either way. We expect trading to be quite volatile."
While it is unlikely the Fed would start bond buying this week, it was expected to at least provide a plan for what traders and investors could expect in the coming months.
The lack of Congressional progress on the Bush tax cut debates has focused attention on what the Fed will do to revive economic recovery. With Congress in "fiscal gridlock," there's pressure on the Fed to provide help.
President of the Federal Reserve Bank of Dallas, Richard W. Fisher, said the government has been handling U.S. tax policy "in a capricious manner that makes long-term planning, including expanding payrolls, difficult, if not impossible. The Fed is not the end-all for curing every economic pathology."
President of the Minneapolis Fed Narayana R. Kocherlakota said that the Fed's policies can only do so much for the high unemployment rate.
"The mismatch problems in the labor market do not strike me as readily amenable to the kinds of monetary policy tools currently available to the Fed," he said. "But they may well be amenable to other types of policy tools, like job retraining programs or foreclosure mitigation strategies."
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