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Fed May Be Forced to Rethink Options: Strategist

The steep drop in stock prices is creating a tightening in financial market conditions that is pushing the Fed into a "zone of action," says Morgan Stanley interest rate strategist Jim Caron.

United States Federal Reserve
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United States Federal Reserve

The Fed was not widely expected to take any action at its meeting Tuesday but a deterioration in financial markets and the economy may force it to rethink its policy options.

Caron said what happened in the markets last week and Monday is the equivalent of a tightening in financial conditions back to the level of August 2010, when the Fed first discussed QE2, its quantitative easingprogram. Under that program, it purchased $600 billion in Treasury securities.

While the Fed is unlikely to announce a major new policy initiative after Tuesday's meeting, it could allude to things that it might do that would stimulate growth. The pressure is also on the Fed to say something soothing after Monday's 634-point drop in the Dow.

"I think to some degree they have to acknowledge the volatility in the markets. They have to acknowledge the downgrade in growth expectations," he said. "They also have to recognize that core inflation, which we expect to be 1.6 percent with the next release, is running higher than when they did QE2. Core was 0.8 percent, and now it's running double that. Additional stimulus comes with a much bigger penalty or charge which is that stimulus usually amounts to increasing inflation and inflation expectations."

"I think that's an interesting issue and hurdle the Fed has...I think given the choice between growth and inflation, they're going to choose growth," Caron added.

Caron said the Fed in its statement could make some reassuring comments on the economy, or provide explicit language in its statement about what it means to hold rates low and keep its balance sheet unchanged, for an "extended" period.

Caron said the Fed could lower interest rates on reserves. It could also shift the duration of the Treasury securities it is currently holding on its balance sheet by using the proceeds of the roll downs from its mortgage portfolio to buy longer duration securities. That purchasing power — about $15 billion a month — could be put towards buying 10-year notes, which would help keep yields low, he said.

The market weakness and the S&P downgrade of the U.S. has spurred a tightening in Morgan Stanley's financial conditions index (below). The financial conditions index is used to interpret market moves during financial easing and tightening cycles.

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