The big story out last night was a Far East combo of central bank action and inaction.
Both were a surprise.
The action came from the Bank of Japan in their quest to stem the rise of their currency and to stimulate their economy.The BoJ started a programof quantitative easing that will see their balance sheet rise by $60 bln as they buy government bonds. They also said they would cut their benchmark rate from 0.1% to 0-0.1%.
The inaction came from the Reserve Bank of Australia, which kept their benchmark interest rate steady at 4.5% for the 5th straight month in a row. Although Reserve Bank Governor Glenn Stevens said that higher borrowing costs may be needed at some point, the central bank is clearly taking a precautionary step to allow for more time before they act.
Both events are indicative of a central bank environment that is worried and interventionist. They point to further bond market rallies leading up to the Federal Reserve's November 3rd meeting. With Pimco’s El-Erian stating that they believe the Fed will restart quantitative easing (QE2), the market isn't waiting for the action and has already aggressively bought fixed income securities in anticipation of lower rates.
The Fed's Dudley laid out the path by his recent speech: "...some simple calculations based on recent experience suggest that $500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point."
He added this disclaimer: "But this estimate is sensitive to how long market participants expected the Fed to hold on to these assets."
It's this last point that will be in play after the Fed's purported announcement on QE2.
The original QE program was a surprise and massive. It helped drive down rates and spur a large bond market rally. Things are not so simple now. Market expectations can drive rates down in anticipation of the action and then back up if they perceive the outcome will be successful. The risk for the United States is that this new QE program is not successful for stimulating the economy.
While lowering rates will be helpful in the short term, can the Fed do more than this?
As Ben Bernanke said in August, there are limits to monetary policy. The Fed won't directly address the most central issue facing the economy: the foreclosure crisis. If this isn't corrected and if solutions can't be made to speed up the housing market correction, then the US economy will continue to be dragged down by lower bank lending, lower consumer spending and lower job creation.
Andrew B. BuschDirector,