Why the Fed Will Intervene If Stocks Fall Too Far

Fed Will Focus on Stock Market Drop

It Probably Will Take a 10% Move to Prompt ActionGross: Fed "Trapped in a Conundrum."

Investors looking for more Federal Reserve intervention can pretty much ignore the economic data and train their sights on one area: the stock market, and how much of a drop it will take before the central bank comes to the rescue.

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Photo: Oliver Quillia for CNBC.com
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Though the recent market selloffis worrisome, it could take as much as a 10 percent drop or more before the Fed acts.

While central bank action ostensibly is geared toward using monetary policy to control the levers of prices and employment, the era of quantitative easing has brought with it increased focus on how the equity markets push the economy, and not the other way around.

As such, Chairman Ben Bernanke and his fellow Fed officials will be paying great attention to whether the sharp stock declineWednesday, as well as the market's generally lackluster performance the past three weeks, signals a need for more stimulus.

"Mr. Bernanke and (former Fed chair Alan) Greenspan made it clear that the stock market is the transmission mechanism for monetary policy," said Quincy Krosby, chief market strategist at Prudential Annuities in Newark, N.J. "They know that a stronger stock market feeds into a stronger economy, which feeds into investor confidence.

"It is an underpinning for that all-important virtuous cycle that Mr. Bernanke and all economists talk about."

Major indexes shed more than 1 percent the day after minutes from the most recent Fed Open Market Committee meeting indicated significant hesitation toward a third round of easing.

While most of the economic datahas been on an upward slope, investors remain nervous over whether the market can stand on its own. Since the financial crisis, the Fed has expanded its balance sheet to nearly $2.9 trillion with bond buying that has helped spur liquidity.

Pinpointing how much the market would need to drop is a difficult exercise, but Krosby said it probably would take something approaching a full-blown correction — or 10 percent drop — before the Fed would step in.

"If the data weakens and begins rolling over, it will reflect in the market and show a repeat of 2011. The Fed is cognizant of that and their time frame for action is very narrow," she said. "A 5 percent pullback now — that goes under the rubric of consolidation and you would have more buyers come back in."

More than that, though, and the Fed is likely to use the lessons of the past two rounds of quantitative easing and take action, which likely would come in the form of $1 trillion or so of mortgage bond purchases.

"When QE1 has ended, when QE2 has ended, basically the stock market has gone down by 1,500 points the next month or two," Bill Gross, co-CEO of bond giant Pimco, said in a CNBC interview. "Is the Fed trapped in this conundrum of providing cheaper liquidity in order to pump up the stock market and risk markets? I think they are. I won't argue...whether it's good policy, but it's necessarily policy based on where central banks have led us."

Gross, too, did not speculate on how much of a drop it would take, but previous Fed actions provide some clues.

The second round of QE followed a 15 percent summer stock swoon, and after Bernanke telegraphed the move in a speech he gave at the annual Jackson Hole, Wyo., summit in late August 2010.

Implementation of QE1 in November 2008 came after a much steeper decline, after markets lost about 40 percent during the height of the financial crisis.

The Fed followed the end of QE2 last year with Operation Twist, a balance-sheet-neutral move in which it sold shorter-dated debt and bought longer maturities. The program was aimed at driving down interest rates, but has coincided with a sharp stock market rally.

"Equity markets around the world didn’t take too well to the prospect that the Fed is set to remove the punchbowl — and with good reason. The recent bout of risk-on investing, as we had predicted, is predicated purely and simply on the success of quantitative easing and the prospect of more in the coming months," Andrew Wilkinson, chief economic strategist at Miller Tabak in New York, said in a note to clients.

Wilkinson sees possible intervention coming, but believes it could be a painful period for investors with a likely "slide in equities to help recalibrate the reality of where the global economy really stands."

"The message from the Fed’s minutes could harshly be interpreted that from here, investors are on their own," he said. "What we had hoped was that such a message would be very apparent to consumers, homeowners and investors who just couldn’t wait to race away from the starting tape. Instead it looks like the economy faces a long, hard crawl."