The FOMC met again today (nice timing on their part given the whole downgrade thing) and there was no QE3 announcement, a decision for further easing would probably have come off as panicky. We did see a promise that interest rates would remain at zero through 2013 though, as the Fed continued its attempts to reassure the market that government handholding would stick around for a while.
If markets continues to sputter though, I would not be surprised to hear an announcement for QE3 at Jackson Hole later this month. Judging by the negative tone in the statement today, QE3 might even be worth a 50-50 bet: "Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in nonresidential structures is still weak, and the housing sector remains depressed."
Furthermore, the Fed's tone about the transitory nature of negative economic indicators (like rising commodities prices) darkened as well. Whereas previous statements this year were adamant that the downward shift in the economy was just a hiccup because of Japan and the Arab Spring, this time the FOMC started to spread out the blame: "Temporary factors, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan, appear to account for only some of the recent weakness in economic activity."
The real kicker is the language noting that the weak economic is "likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013." This is a bold statement. It means ZIRP, which started in 2008, for a minimum for five years! For the first time in years there were three dissents to the statement, specifically the use of 2013 language instead of the previous "extended period" phrase.
Here is the question, how can we trust this policy action to be right? Even the FOMC has admitted they really don't have a good idea about what they are doing, given that they were projecting 3 percent GDP growth this year, but now expecting "a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased."
In reality, the Fed could change course next year if the economy surprisingly grows or if banks look to be collapsing from lost revenues. The prolonged low interest rates have allowed the banks to borrow for next to nothing, but returns on asset investments are also depreciating, and could get worse over the next 12 months, forcing the Fed into a rate increase.
The Fed see's its options at limited right now, other than long-term ZIRP. Chairman Bernanke has publicly commented that the value add of QE3 is small and risky, but the Fed has also carried the mantle of economic savior during this whole financial crisis and aftermath so it would be consistent for them to try and save the day once again. Never mind that their activities have just driven up the stock market while ignoring rising costs for consumers on Main Street. Saving Wall St. is not the same as saving the U.S. economy.
Is there anyway the Fed can save the day or calm markets? In theory the Fed could announce a continuation of its quantitative easing program in hopes it might provide a heroin shot to the system so long as investors don't see their action as a Hail Mary. Basically it would be more of the same we saw in QE2, buying up U.S. Treasuries from financial firms, giving them cash to work with and keeping interest rates low. The financial industry would love more free cash to play with in asset markets, as they have been doing in the past few years, but banks are unlikely to change course with QE3 money and lend that out into the economy en masse.
One problem for the Fed is that market actors are not all of one mind. Some fear deflation, others fear inflation. A single policy solution is not going to satiate everyone's fears. Further monetary expansion will fill many near-term traders with glee as they take cheap money and turn it into speculative profit. Investors looking at the long-term though will probably coil back in fear on inflation worries. The same thing would go for my preferred solution, which would be to announce an exit plan at the next FOMC meeting and begin to unwind the Fed balance sheet later this year. Some would cheer, others would moan.
When it comes to the Fed considering its options one has to consider the problems. And other than buying up all the debt remaining in the system, Bernanke can not do much. We are in a contracting economy that was goosed by debt but is now deleveraging. Until that stops we will suffer. We have a housing system weighing down bank and home balance sheets. Until that is worked out, with prices coming down to historical trends and the supply reduced we will suffer. And we have a tax code and regulatory system stifling real, sustainable growth. Until we see tax code reform and a change in the regulatory system towards forcing private sector accountability instead of depending on watchdogs we will suffer. There is not much the Fed can do about those things beyond taking on all the debt or buying up all the houses. They could, and should, push for changes in the regulatory system, but since Bernanke has more or less been championing Dodd-Frank I don't see that happening in the near future.