Liesman: Two Possible Results from Fed Meeting

Federal Reserve
Federal Reserve

The Federal Open Market Committee begins debating Tuesday what will almost certainly result in a new program to purchase assets in an effort to stimulate the economy.

But the size and timing of those purchases is uncertain and one reason could be because of an effort by the Federal Reserveto craft a policy that will account for two disparate forecasts that surround its base case of moderate growth.

One outcome—the possibility of another recession—will motivate the Fed to act and likely in a substantial way. The second scenario, the chance of better economic growth, could limit how much the Fed does.

The good growth story inside the Fed begins with the huge amount of monetary stimulus in the system, including a $2.3 trillion Fed balance sheet, up from $800 billion before the Fed started buying assets in mid 2008. Fed economic models tend to put a lot of weight on financial conditions, including the current higher level of the stock market, low interest rates and additional quantitative easing (QE).

Second: the Fed continues to believe in the general rule of thumb that recoveries pick up steam over time. It could be that the course of the recovery was halted by the panic over European sovereign debt. The result is that economic forecasts have continuously been marked down since April. That process may be near an end.

Third: consumer debt ratios are down, savings rates are up and consumer spending growth hasn't been too bad at about 2.4 percent on average over the past two quarters. Meanwhile, equipment and software spending by corporations has been reasonably healthy and companies remain flush with cash that could be deployed to spur growth.

Fourth: net trade, which has curiously been subtracting from growth, is likely to at least be neutral in coming quarters.

No one inside the Fed is getting too carried away with this optimistic scenario. It can seem a path to better growth, but it’s not the base case of the majority of the committee. The base case is moderate growth that struggles around the 2 percent level and accelerates in 2011.

The operating or motivating worry at the Fed stems from that base case: that the economy doesn't grow fast enough to lower unemployment. In fact, unemployment could continue to rise if the economy continues to grow below its potential of around 2.5 percent to 3 percent.

That creases a worry of a potential "stall speed," where the economy tips back into recession. A host of economists have warned about this concern, including Paul McCulley of Pimco and Stephen Roach of Morgan Stanley .

For Fed Chairman Ben Bernanke, the risk of a stall speed would appear to be greater than the possibility that the economy quickly hit escape velocity.

So how does the FOMC and the Fed take account of these disparate forecasts?

First, it addresses the most pressing concerns: that of deflation and the economy slowing to a stall speed. That’s the basis for the QE program.

But second, the Fed does so in a way that is conditional on incoming economic data. A policy could look something like this: an initial “down payment” in the words of UBS Chief Economist Drew Mattus. He puts it at $200 billion, but I believe a larger number of $300 to $400 billion is more likely.

At $300 billion, this would amount to $50 billion of Treasury bond purchases over a six-month period. The Fed then makes clear to the market that additional QE could come if the economy is not a path to what Bernanke has called the “mandate-consistent inflation rate” of 2 percent or just a bit below.

Our CNBC Fed Survey shows the market is looking for about $460 billion in stimulus to be announced from the Fed. I think it’s likely the Fed ends up on the lighter side of that number, but with an open-ended provision that could allow it to get there if the economy doesn’t pick up. But the policy would also not commit the Fed to going further if the better growth scenario looks likely.