Will the Fed Extend QE3?

After the recent market slip - down 6.8% in less than one month - the big question this week is will the Fed extend QE3?

The U.S. Federal Reserve hasn't been able to keep its mouth shut during these volatile times. Just look at how the Fed responded to the last month of market activity...

On Sept. 24, the Dow Jones Industrial Average headed to an all-time high. The index sat at 17,210.06, just below the record close the week before. Repeated record highs have been common in this Fed-induced, five-year bull market.

Then the next day, the Dow dropped 264 points. But the Fed wasn't ready to let traders get the better of it.

Fed monetary policy dove and Federal Reserve Bank of Chicago President Charles Evans led the charge. He tried to prop up the markets with talk that the Fed would not hurry to raise interest rates, against the words of some of his more hawkish colleagues.

"I am very uncomfortable with calls to raise our policy rate sooner than later," Evans said on Sept. 29 in a speech at the National Association for Business Economics, The Wall Street Journal reported. "I favor delaying liftoff until I am more certain that we have sufficient momentum in place toward our policy goals."

will the fed extend qe3?
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It may not have reignited the Dow to a new high, but it did allow it to steady for a couple of days. It ended the week just above 17,000.

The next week, however, brought a 273-point drop in the Dow. And the Fed doves used the opportunity once again to talk interest rates.

This time it was New York's Federal Reserve President William Dudley who looked to reassert to the markets that interest rates would not take off until mid-2015.

"It still is premature to begin to raise interest rates - the labor market still has too much slack and the inflation rate is too low," Dudley said, as reported by the Journal on Oct.7.

His remarks helped support a quick sprint back to 17,000.

That Fed-driven market optimism lasted only a day. On Oct. 9, the drop that ignited what was almost a full-on correction happened: a 335-point freefall in the Dow.

In the week to follow, the Dow erased all of its gains for the year and fell to 16,117.24, a bit short of a 10% correction.

And the Fed, once again, couldn't stay quiet.

The Fed Sparks Talks of an Extended QE3

This is when talks of extending QE3 began.

"Inflation expectations are declining in the U.S.," St. Louis Fed President James Bullard said in an interview with Bloomberg News on Oct. 16. "That's an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE."

So is Bullard on-point? Will the Fed delay the end of the taper expected in October?

Probably not.

Market movements don't explicitly determine Fed policy.

While the slump in the broader markets "will certainly cause a discussion" among the Fed policy makers, it isn't a determinant in monetary policy decisions, said Cliff Rossi, professor of the practice at the University of Maryland's Robert H. Smith School of Business.

Instead, the Fed is looking at inflation and growth and then "they'll make a determination as to whether they need" to extend QE3, Rossi said.

"If it's a significant correction that could be different story," Rossi added.

Though the market has rebounded over the last week, and the Fed's policy-setting Federal Open Market Committee (FOMC) will release its statement Wednesday, there is very little time for an earth-shattering plunge or deep correction to spook the Fed.

So, why are the Fed doves getting louder when the market plunges if they don't intend to let that influence their decision?

The Fed's Game with the Markets

Money Morning's Small-Cap Specialist Sid Riggs said it's simply a game the Fed is playing with traders to keep the Fed-induced rally from dying out.

"The Fed has inflated its balance sheet and almost in lockstep with its balance sheet expansion the stock market has gone up," Riggs explained. "The Fed has created an artificial asset bubble and now they've kind of taken away the punch bowl."

As talks of winding down QE3 abound, and global growth slows, traders are no longer allowing the Fed to keep the artificial market rally going.

And that's why even as the easy money spigot is coming closer to being turned off, the Fed is not ready to let the markets fall.

Now, traders aren't going to let the Fed get away with hollow speeches that only speak in hypotheticals. They want to see clear policy proposals. They won't let the Fed continue to benefit from a market rally as long as it is being coy.

"Traders are forcing the Fed's hand because the Fed has floated three times that they would not be as tight with money and not be so quick to raise rates," Riggs said. "Traders are sending the Fed the message that that's not enough."

"I would suspect that we would see the market sell off more until the Fed capitulates to traders and makes some kind of official announcement about what they intend to do."

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