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Fed Considers More Easing: What Are They Thinking?

Ben Bernanke
CNBC.com
Ben Bernanke

With the market barely given enough time to digest the last easing drive, talk already is emerging that the Federal Reserve is getting ready to rev up the engine again.

Chairman Ben Bernanke, in his thus-far unsuccessful quest to resuscitate the moribund housing market, is making his case for another round of easingin which the central bank would buy up mortgage-backed securities, according to a report in Friday’s Wall Street Journal.

The effort would target bringing down mortgage rates, which already are near historically low levels and have yet to do much if anything to rejuvenate real estate.

Still, Bernanke appears determined to make sure the central bank remains an active partner in trying to stimulate growth.

It’s all part of the Fed’s efforts to create what the chairman calls a “wealth effect,” or a sentiment among the public that if prices of risky assets such as stocks go higher it will stimulate confidence that ultimately will generate wealth.

“Financial conditions have eased, but they are not easy enough,” Jim Caron, head of global interest rate strategy at Morgan Stanley, writes in response to talk of more easing. “The Fed will keep acting to ‘ease’ policy until they get the market response they want, which is to reflate risky assets.”

The problem Bernanke has run into these days when convincing the Fed Open Market Committee to do more easing is the fear that such actions will create inflation.

So far, the efforts have put core inflation—which only measures prices outside of food and energy—right around the Fed’s target rate of 2 percent. Headline inflation, though, which takes into account the prices that normal Americans confront in their daily lives, is just under 4 percent.

But Bernanke’s ace in the hole for getting a third round of quantitative easing—QE3, in market parlance—is that unemployment remains stubbornly high at 9.1 percent despite the inflation rate.

“The primary transmission mechanism for the Fed to ease financial conditions is the creation of an environment in which real rates remain lower than they otherwise would be,” Caron writes. “This can be done by increasing inflation expectations, which will also encourage a reflation of risky asset prices. We interpret a rise in risky asset prices as a form of stimulus via: i) the wealth effect and ii) by encouraging risk taking and investment. In theory, this may extend to business investment and ultimately hiring.”

Ironically, then, Bernanke can use the unemployment picture, which is nearly as bad as the housing market, as a means to justify his ends of still more easing beyond the current round.

Operation Twist, announced in mid-September, allocated $400 billion toward selling Treasurys at the shorter end of the yield curve and buying longer-duration bonds, pushing the central bank’s balance sheet past the $3 trillion mark. Ostensibly, the objective was to lower long-term borrowing rates to stimulate activity. That didn’t happen, but the stock market has been climbing higher.

Still, Bernanke may not be satisfied that the market’s rise hasn’t done much for anything else, and recent statements from him and other dovish FOMC members represent “a campaign by the Fed to redefine its unofficial goal of inflation and to allow them to pursue an easier policy,” says Mark Pawlak, equity strategist at Keefe, Bruyette & Woods.

“At the very minimum, we think that means the Fed will formally or informally tell the markets they are on hold until either an inflation or unemployment rate target is reached,” Pawlak wrote in an analysis for clients. “At the maximum, it means the likelihood of QE3 is much higher in our view than those in the markets and the general economy realize.”

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