Standard economic textbooks teach that the Fed has essentially two means of providing stimulus to the economy. The first tool is lowering the fed funds rate. The second tool is "open market operations" in which the Fed purchases securities on the open market (e.g. QE).
The Fed has reached the limit of what it can do with the first option: the fed funds rate is near 0%.
In terms of the second option, the Fed has already implemented QE1 and QE2. Many analysts feel that the Fed has reached its limit as to what it can do with QE.
Indeed, it has become more or less the consensus that given what the Fed has done already, the U.S. central bank is "out of ammunition" and can do nothing to help the economy at this point. This skepticism has raised the stakes for Bernanke's annual speech at Jackson Hole. The prospect of an economy and financial markets without credible Fed support is creating much anxiety.
Many people feel that if Bernanke's is not able to outline a credible plan of action, financial markets will indeed conclude that the Fed is "out of ammunition." This realization that the Fed is "powerless" in the face of enormous contractionary and deflationary forces in an economy that is deleveraging could potentially set off a financial and economic panic.
The Policy MenuIn a series of articles, I have addressed this issue of the Fed's policy options and the power that the Fed has to counteract contractionary and deflationary forces.
On the one hand, I have acknowledged that some proposed solutions are unlikely to gain traction given their limited expected effectiveness in the current environment relative to their costs/risks. For example, I have argued that lowering the interest rate that the Fed pays banks for holding excess reserves at the Fed is a policy that would entail many risks with relatively few discernible benefits. I have also argued that an "Operation Twist" would make little sense in the current environment.
On the other hand, I have pointed out the potential effectiveness of certain Fed alternatives. First, I have argued that the pledge to keep the Fed funds rate at 0% for two years is a more significant policy initiative than many have given it credit for. Second, I have laid out a powerful menu of policy options that the Fed has to prevent a debt-deflation depression scenario from unfolding. Indeed, I have argued that the Fed has thus far hardly touched the surface of the sort of things it could do.
With regard to the Fed's policy options, I have attempted to lay out a possible framework that might make such policies institutionally and politically viable.
For example, I have suggested that a policy framework based on "nominal GDP targeting" could provide the institutional "patina" that the Fed would need to be able to effectively implement some of the more radical options outlined in my monetary policy menu. It also would provide political cover with the center-right as this approach is actually more "rules-based" and less discretionary than the current framework - a policy virtue sought after by conservatives.
Furthermore, I have floated an idea which I believe holds some promise as a potential means of the Fed engaging in monetary stimulus, if the need arises. Specifically, I believe that the Fed has an opportunity to tackle the housing problem in the U.S. in a way that can be economically significant. And I believe that a policy specifically targeted at the housing market - and low and middle-income households in particular - would have widespread political appeal (despite the predictable objections on the fringe).
The idea behind these proposals is not to make policy. The idea is to try to imagine what the Fed could do as well as what it is inclined to do. Determining capability and inclination is very important from the perspective of investment management - whether it be equities (SPY, DIA, QQQ) or fixed income (TLT, JNK).
The Fed's InclinationsAbove, I have outlined the Fed's capabilities. Now, let us turn to inclinations.
From Bernanke's past writings and speeches and, more importantly, from his actions as Fed Chairman, it is clear that he favors activist policy in the face of any threat of depression or deflation. At the same time, it is clear that the Fed does not operate in political vacuum. And in this regard, there does not appear to be widespread political consensus for aggressive Fed intervention at this time.
What To Expect From Jackson HoleIt is my assessment that the Bernanke will not announce any concrete actions in the course of his Jackson Hole speech due to the current lack of political consensus regarding Fed action. I believe that Bernanke will wait until the economy is unmistakably in dire straits before actually "pulling the trigger" on some of the aggressive alternatives available to him and which I have outlined in the articles cited above.
Having said that, I think Bernanke may choose to remind financial markets, and the public at large that the Fed is far from powerless in the event that the economy showed confirmed signs of deteriorating further. Bernanke might suggest various possible courses of action that the Fed might eventually take in such a circumstance.
The knowledge on the part of financial markets and the public at large that the Fed is not "powerless" could have a reassuring effect on markets - which is precisely what Bernanke's intention would be in giving such a speech. Such a speech would also serve as a political sounding board to gauge potential political support/opposition to various policy alternatives.
ConclusionI believe that the Bernanke will deliver a speech at Jackson Hole that is calculated to dispel the notion that the Fed is powerless in the face of a severe economic contraction and/or deflation. I believe that Bernanke will use the Jackson Hole platform to signal the Fed's intent to act aggressively in such an eventuality.
At the same time, I believe that the Fed will make no policy commitments. Bernanke will merely say that the Fed is closely monitoring the situation and stands ready to act, if necessary.
In my opinion, this approach by Bernanke will neither energize markets nor disappoint them. I expect the initial reaction to the speech to be muted.
However, for reasons that I have outlined elsewhere, I believe that the U.S. stock market will soon focus on the terrible August data reported in September. Furthermore, companies may begin to issue lowered guidance.
Time will tell whether the fear occasioned by the terrible numbers published in September will force the Fed's hand as well as provide sufficient political cover for the Fed to take aggressive countercyclical actions. My expectation is that we will soon find out - i.e. within the next couple of months.
Disclosure: I am short TLT and long TBT and SBND.
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