Why Federal Reserve Chairman Ben Bernanke Can’t Deliver QE3

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August 26, 2011 11:49am NYSE:TBT NYSE:TLT

David Zeiler:  U.S. Federal Reserve Chairman Ben S. Bernanke has a choice to make this morning (Friday) before giving his Jackson Hole speech.

And he can’t win either way.

Bernanke can telegraph a third round of quantitative easing (QE3), which most economists believe would at best be ineffective. Or he could do nothing to reassure the markets that have already priced in another $500 billion to $600 billion of central bank U.S. Treasury purchases.

In either case, the outcome won’t be pretty.

Many analysts already have questioned the effectiveness of QE1 and QE2, and even the ones that don’t are pessimistic about the potential outcome of QE3.

Money Morning Chief Investment Strategist Keith Fitz-Gerald said that although the markets may be looking for QE3, it would be a bad idea.

“It has never worked since the dawn of recorded time and it will not work now,” Money Morning Chief Investment Strategist Keith Fitz-Gerald said on the Fox Business program “Varney and Co.” “You cannot debase your currency and work your way out of this for anything but a short-term basis.”

However, should Bernanke indicate the Fed is not considering QE3, the markets – which have risen about 5% this week — could choke on the news.

“The market’s sending a signal to Bernanke saying, ‘We want QE3 and we want it this week, or we’re going to hammer you and the market will get absolutely killed,'” Keith Springer, president of Springer Financial Advisory, told CNBC.com. “The stock market is addicted to QE.”

Third Time the Charm?

Some observers viewed the week’s glum economic reports on housing, manufacturing and unemployment as possible catalysts for Fed action.

“It’s almost as if negative news is being priced in as something positive because it underscores the argument that the Fed needs to do something,” Abigail Huffman, director of research for Russell Investments, told The Wall Street Journal. “People are hedging their bets. They’re hoping for the best and positioning for the worst.”

Another reason investors have cause to think Bernanke will raise the possibility of QE3 is that he first mentioned QE2 at the same Jackson Hole event, an annual Federal Reserve symposium, last year.

The Fed launched QE2 last November and concluded it this past June. The move helped push markets higher for eight months.

“We believe Bernanke’s Jackson Hole speech will include a detailed discussion of the potential for more easing through large-scale asset purchases,” Goldman Sachs Group Inc. (NYSE:GS) economist Zach Pandl wrote in a note. “A variety of indicators suggest many investors already expect more QE.”

Voices of Dissent

Of course, not everyone believes Bernanke will give the market what it craves.

“Bernanke is not planning any new policy pronouncements at the annual Jackson Hole gathering, but he will reassure markets the Fed stands ready to continue deploying what is left of its tools to bolster recovery should recession risks increase,” according to a Medley Global Advisors note to clients.

“While markets believe the language change clearly opens the door to another round of quantitative easing, the threshold for initiating fresh Treasury purchases – so-called QE3 – remains far higher than markets realize,” the Medley report said.

In fact, even if Bernanke believes another round of quantitative easing is warranted, he’ll run into several points of resistance that he didn’t face last year:

  • Internal Dissent: At the Aug. 9 meeting of the policy-setting Federal Open Market Committee (FOMC), three of the 10 board members voted against the decision to hold interest rates at their current low levels through June of 2013 — the most dissent within the FOMC in 20 years. That group would strongly object to QE3.
  • Conservative Climate: The recent debt-ceiling debate resulted in a bias in Washington against further stimulus spending of any kind. Although the FOMC operates independently of Congress, it would be reluctant to stir up that hornet’s nest by voting for QE3.
  • Inflation: Last year inflation was hovering around a 1.2% annual rate – so low the Fed actually feared deflation was a possibility. But inflation now is running at a more worrisome 3.6%, with many blaming QE1 and QE2 as the primary culprits.
  • Balance Sheet: After the first two rounds of quantitative easing and the purchase of mortgage-backed securities, the Fed’s balance sheet already stands at a bloated $2.8 trillion.
  • Trade Partners: The Fed’s policies of low interest rates and easing have reduced the dollar’s value against most foreign currencies, which has made U.S. exports cheaper and foreign imports more expensive. That’s been good for U.S. companies but has angered many trade partners, particularly Brazil, who would see further bond purchases as part of a currency war.

More Harm Than Good?

All that may explain why economists, unlike investors, are unenthusiastic about the possibility of QE3. A majority of economists surveyed by CNNMoney – 12 out of 16 – said they believed the Fed should not take further action despite worsening economic news.

“It’s premature, and the potential costs exceed by a wide margin the possible benefits,” Patrick O’Keefe, director of economic research for accounting firm J.H. Cohn, told CNNMoney. He said further Fed action “would be equivalent to serving ice cream cake as the main entree at a weight loss clinic.”

And given that the economy has weakened in recent months, despite QE2, many wonder just how much good a third round of easing would do.

“Any action the Fed takes at this point may give the markets no more than a temporary lift and would not resolve the more fundamental problems that are weighing on the economy,” Deutsche Bank AG (NYSE:DB) chief economist Peter Hoopersaid in a research note.

Some observers speculate that Bernanke could attempt to satisfy the markets with some other policy options, such as promising to buy maturing notes, or even reviving an idea from the President John F. Kennedy era, “Operation Twist.”

That policy, named for the famous Chubby Checker song, flattens the yield curve by selling shorter-term notes and using the proceeds to buy longer-term Treasuries.

But despite the mood among investors that Bernanke needs to do something to spark the economy – QE3 or otherwise – the Fed has exhausted most of its options.

So the markets should get a pat on the head today – but no QE3 lollipop.

“He will explain what the Fed has done and the costs and benefits of its remaining policy options,” Michael Feroli, chief U.S. economist at JPMorgan Chase & Co. (NYSE:JPM), said in a research note. “But we would expect him to leave it at that, and not forcefully signal that a given course of action has already been decided upon.”

Related:  SPDR Gold ETF (NYSE:GLD), iShares Silver Trust (NYSE:SLV), iShares Barclays 20+ Year Treasury ETF (NYSE:TLT), ProShares UltraShort 20+ Year Treasury ETF (NYSE:TBT).

Written By David Zeiler From Money Morning

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