Sun, Aug 21, 2011 - Page 9 News List

Fed may have bullets left, but are they blanks?

While the Federal Reserve still has a few tools left at its disposal to try and kick-start the US economy, some investors fear that the growing politicization of Fed policy could impair its independence

By Steven Johnson  /  Reuters, NEW YORK

Illustratiob: Tania Chou

When US Federal Reserve Chairman Ben Bernanke takes the podium this 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 is almost as if the second round of quantitative easing (QE2), the Fed’s US$600 billion bond-buying program first mentioned at last year’s meeting and designed to boost the struggling economy, never happened.

That is not to say investors doubt the central bank’s resolve to act again if the US economy keeps losing steam. Last week, it surprised markets with an unprecedented pledge to hold interest rates near zero until at least 2013.

However, given questions about the efficacy of monetary stimulus to date and a growing political backlash against the Fed’s policies, investors expect the US central bank to keep its powder dry at this year’s Jackson Hole symposium from Aug. 25 to Aug. 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 is 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 is the problem of ever diminishing returns. The benchmark Standard and Poor’s (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 about 1,200, the index is off its Aug. 8 low, but trading remains volatile.

President of the Federal Reserve Bank of Atlanta Dennis Lockhart has said the central bank could buy more long-term bonds to lengthen the duration of its portfolio, which would flatten the yield curve and allow homeowners to refinance at lower interest rates.

However, with rates already low, the impact may be muted.

Moreover, investors said lower 30-year bond yields could actually complicate life for insurance companies that have to match liabilities and assets.

Then there is the limited impact the Fed’s quantitative easing 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 a rate of just 1.7 percent this year, well below the Fed’s June forecasts of 2.7 to 2.9 percent.

Including QE2, which ended in June, the Fed has spent about US$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 US 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. “So you actually robbed consumers of purchasing power.”

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