Tuesday, August 23, 2011

Limited Options for Monetary Policy

During my lunch break at work, I typically read books on my kindle while using the elliptical in our office’s gym. Following today’s unexpected earthquake, I embarked on my normal routine. Unfortunately, mid way through my work out the kindle ran out of power. At that point I resigned to watching CNBC for the remaining 25 minutes. Needless to say, I was quickly reminded of the reasons I gave up watching the channel in the first place. During this short period of time, the guest host for the hour proclaimed both that second half growth would be supported by lower oil prices and he expected oil prices to move higher. This fits with other recent bullish remarks noting how equity markets would respond positively to lower oil prices while ignoring that Exxon and Chevron account for more than 10% of the Dow (and were the market leaders during today’s steep gains).

Among other misplaced comments by the guest host was his claim that markets were not expecting any policy change from the Fed Chairman Bernanke during Friday’s speech at Jackson Hole. Apparently he’s missed almost every news story the past week and simply ignored the CNBC commentators, who were proclaiming today’s rally was due to expectations of QE3. Luckily for this host, a separate market commentator made (in my opinion) an even more ridiculous statement during the same short time frame. Speaking about the oil market, this commentator said that any mention by Bernanke about potential future policy options would imply QE3. Maybe this commentator isn’t aware of Bernanke’s past, but throughout much of his career as a professor, Dr. Bernanke outlined creative means for implementing monetary policy in order to avoid repeating the Great Depression or to end Japan’s deflationary trend. There is basically zero chance that Bernanke or any Fed Chairman in the near future publicly states that the Federal Reserve is out of potential policy options.

From my perspective, market bulls are probably holding their overweight long positions in hopes the Fed announces further stimulus. Market bears however may have started covering positions aggressively having witnessed an elongated period during which the Fed has tried one trick after another to prop up equity markets. Going into Friday’s speech, being short appears the scarier position. However, if Bernanke fails to announce or implicitly suggest a policy change, I have a feeling the tables will turn very quickly.

Previously I’ve outlined why QE2 failed and further quantitative easing in a similar fashion would be equally ineffective. I believe the Fed has begun to recognize this fact and Bernanke will present other options available to the Fed, primarily for use if inflation expectations begin falling back towards zero. One of my favorite bloggers, Cullen Roche at Pragmatic Capitalism, wrote a post today discussing the remaining policy options available to the Fed and their individual merits. For anyone curious about the possible options Bernanke will outline or the current potential of monetary policy, the following piece is a must read.


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