Federal Reserve Chairman Ben Bernanke took another step toward signaling further monetary stimulus Friday, but in doing so left one key issue unanswered: What if all this intervention causes more harm than good?
Results for the central bank's liquidity program—commonly referred to as quantitative easing—have been mixed at best so far. Unemployment remains high, the housing market hasn't recovered and consumer confidence is still low.
So the notion that printing another half-trillion-dollars or more might not make a difference is something that's keeping some market pros up at night.
"We haven't seen much bang for the prior buck from all of the stimulus that they gave us through the first half of the year," says Kim Rupert, managing director of global fixed income analysis for Action Economics in San Francisco. "I'm not so sure that we're going to see any rapid improvement on this round, either."
Worries about all the things that can go wrong with more Fed easing can be broken into five categories:
1. Too Much Intervention
Many strategists and analysts would be just as happy to see Bernanke and his Fed cohorts butt out and let the market find a normalization level on its own.
Currency manipulation and hand-holding of the stock marketcan't last forever, and the time is going to come eventually where the Fed will have to cut itself loose.
Treasury yields have fallen more than a quarter of a point since the Fed indicated in mid-September that it would move if necessary to bolster growth.
"We have the biggest player on the block, the Fed, with an infinite amount of buying power keeping rates extremely low. It just prevents the normal workings of the market," Rupert says. "The Fed is deciding who is going to be the winner and who is going to be the loser in this game."
2. Too Little Intervention
And there's the flipside of the argument: If the Fed does decide to launch another easing program, the risk is that it makes no one happy by intervening too little to make a difference.
Analysts have long questioned the size of the interventions, reasoning that a $500 billion boost might only move gross domestic product by a quarter point or so.
Should the Fed fall short, the October rally may reverse itself as the market has priced in the expected level of QE and may revolt at anything less.
"Overall, the Chairman's speech contained more dithering than we had hoped," Zach Pandl, economist at Nomura Securities in New York, wrote in a note to clients. "This means Bernanke truly sees high risks to further easing (where we do not), or indicates a greater division of views on the committee."
Inflation, Banks and Bullets
3. Too Good at Creating Inflation
While Bernanke has been fairly transparent regarding his desire to inject the economy with a healthy level of inflation after such a long downturn, the fear here is that once it starts it may be hard to stop.
"Everybody's worried that there are so much assets that we start another bubble," says Kurt Karl, chief US economist at Swiss Re in New York. "That's a problem for the global economy and it loops right back to the US economy, which has potential inflation a couple-three years down the road. It definitely will be a growing concern of the markets this time next year if we go with quantitative easing."
What form that inflation takes and its origin is a little less clear, but some economists see it beginning in emerging markets and flowing back to the US through intense dollar supply.
"It's not a trivial risk. It's a delicate balance they have to do of stimulating the economy and avoiding too much inflation and some kind of bubble later," Karl says. "Everybody's beating up on the Greenspan years, but they dealt with the economy with the information they had at the time. It's only clear it's a policy mistake in retrospect."
4. Forgetting About the Banks
Moral hazard be damned, banking stocks have been laggards during the autumn rally in part because unlike the first round of easing, QE2 contains no similar provision to help out financial institutions. They'll need something now to get back on track.
In QE1, there were housing tax credits and assurances to prop up the banking system through whatever unconventional means necessary.
This time around, Bernanke and other Fed officials have been noticeably quieter about the need to keep banks solvent.
The foreclosure crisis hasn't helped bank stocks, no doubt, but the lack of Fed support could also damage the sector and undermine a broader market recovery.
"The biggest difference between QE1 and QE2 will likely be performance of US bank stocks," Bank of America Merrill Lynch analysts wrote in a note to clients. "Why? Because QE1 (was) complemented by policies to boost housing/consumption e.g. Cash for Clunkers, homebuyer tax credit, reduced withholding of federal taxes. QE2 won't do it for the banks unless (there are) a. tax cuts and b. payroll growth."
5. Running Out of Bullets
Fed supporter insist that the central bank has plenty left in its toolbelt to help fix the economy. But if QE fails as the Fed's balance sheet approaches $3 trillion, that will become an increasingly difficult argument to make.
"In essence they're trying to induce a recovery. Can it be done? Well, we're going to see," says Quincy Krosby, general strategist at Prudential Financial in Newark, N.J. "The question is, What happens if you don't get people to go out and buy houses? What happens if you don't get a sense of confidence coming back? The worry is, if this doesn't do it the Fed has nothing left."
The gauge for Fed effectiveness will be unemployment and housing, for sure, but it also will be the stock market.
The main goal of QE, after all, is to get people to start spending money and to take a little risk again, something the stock market does a great job of reflecting.
"If we don't see that (QE is working) this stock market is going to make an assessment that none of this works. Ultimately, we have to see this money making its way through the system," Krosby says. "The market reaction will be quite negative."