With the economy still very weak, more stimulus is certainly needed. However just because the U.S. economy desperately needs a jolt of energy does not mean that the Fed will supply it. The topic of Bernanke’s 10am ET speech tomorrow says it all. He plans to speak about the “near and long term prospects for the U.S. economy.” In 2010, the topic of his speech was “The Economic Outlook and the Federal Reserve’s Policy Response.” The big difference between this year and last is that we are now talking about inflation and not deflation risks. Recent economic data has been mixed but at the end of the day, the performance of the U.S. economy has been subpar and for this reason, we do not rule out slightly more aggressive action by the Fed.
From the most flimsy to the most aggressive, here are 5 of the Fed’s options. We believe that the central bank will opt for either an ambiguous pledge to do all that is necessary with no concrete commitment, extend their 2013 low rates pledge to the securities portfolio or sell short term bonds and buy longer term bonds to "twist" the yield curve.
1. “We are also worried” – If the Fed opts to do nothing more than express their concern about the economy and give an ambiguous pledge to do all that is necessary, investors will be sorely disappointed.
2. Extends 2013 pledge to Securities Portfolio – When the Fed met earlier this month, they tweaked the extended language sentence of their FOMC statement to say that the Fed Funds rate would remain at exceptionally low levels at least through mid 2013. They can opt to extend this pledge to their securities portfolio which leaves open the door to QE3 without explicitly initiating it.
3. Operation Twist – The Fed could also bring back a tool used in the 1960s that twisted the yield curve by selling short term bonds and buying longer term bonds. This would drive short term yields up and long term yield down which effectively extends the maturity of their securities portfolio without increasing the balance sheet. This would be a more aggressive action than another language tweak (see #2).
4. Reduce Interest on Reserves to ZIRP – The central bank could also cut the interest paid on reserves from 0.25 percent to 0 percent or cut swap line rates in order to bring down the tremendous amount of liquidity.
5. Another Round of QE – The most aggressive options would be for the Fed to introduce another round of stimulus but given the level of inflation and the criticism of QE2, this option may be the least likely. One other possibility is inflation targeting but this “nuclear option” is so unlikely that it is not allocated its own category.
http://www.fx360.com/commentary/kathy/6024/usd-what-to-expect-from-jackson-hole.aspx
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