All eyes will be on Federal Reserve Chairman Ben Bernanke when he takes the podium on Friday morning at the central bank’s annual confab in Jackson Hole, Wyo.
Bernanke used the same speech a year ago to hint at a second round of monetary stimulus. Two months later, the Fed commenced a $600 billion purchase of bond-buying in a move known as quantitative easing, or QE2.
This time will be different.
“Unless there is a major geopolitical event or an utter meltdown in the market next Friday, there will be no new policy announcement,” analysts at J.P. Morgan Chase predicted in a statement. Inflation, one of the key reasons the Fed decided on QE2, has picked up since last summer. And the policymaking Federal Open Market Committee was divided on the central bank’s most recent decision to keep interest rates at rock-bottom levels through mid-2013, suggesting that Fed officials are not unified on a forthcoming course of action.
Analysts do expect the Fed chair to keep his options open for future action. The possibilities range from altering the central bank’s balance sheet to lowering its interest rates to changing its public communications.
Bernanke isn’t going to announce any new stimulus program or make any significant changes to the central bank’s economic outlook, according to Ryan Sweet, senior economist at Moody’s Analytics. That sort of action would occur at an FOMC meeting. The next meeting is scheduled for September 20, and Bernanke won’t want to appear to be too far out ahead of the committee, Sweet said.
The Fed will wait for more information before announcing another monetary stimulus, said Nariman Behravesh, chief economist at IHS Global Insight. New economic data will help the central bank assess whether the slowdown in the first quarter of 2011 was a temporary blip or something more sustained. The Fed will also wait to see what Washington does this fall. “They’re keeping their powder dry,” Behravesh said.
“Last year, [Bernanke] surprised the markets,” he added. “I think he’ll try to play his cards carefully” this year and keep the Fed’s options open without committing to a specific course of action.
One of those options is for the Fed to tweak its communications strategy to alter market expectations, as it did when it pledged on August 9 to keep interest rates near zero through mid-2013. This time, the central bank could discuss inflation- or price-level targeting or reinvestment policy.
The Fed could also knock interest paid on excess reserves down to zero, which would create an incentive for banks to lend. It could also take the bolder step of making interest rates negative, essentially charging a penalty for banks to keep reserves at the Fed.
Sweet says the Fed would get the “biggest economic bang” from changing the size or composition — or both — of its balance sheet. Altering the size could occur through large-scale asset purchases, or QE3. The composition could be changed by taking some of the proceeds the Fed is currently reinvesting and purchasing longer-term Treasuries. That would basically shift the sheet towards longer-dated maturities, which could help lower long-term interest rates.
Fed action will hinge on its inflation outlook. The FOMC called the long-term inflation outlook “stable” in early August, and Bernanke will likely keep to that assessment and dispel inflation fears on Friday, Behravesh said.
But if the Fed catches a “whiff of deflation” this fall, it will probably respond aggressively, Sweet said. The Fed has a time-tested playbook for higher inflation but not for deflation and so would act aggressively to protect the economy from falling into a deflationary trap.
Bernanke could order the Fed’s options, indicating what the next action may be. Sweet called the odds of "QE3" taking place this year or early next “better than even.”
The Fed’s remaining options, if enacted, may only have a marginal impact on the economy, Gregory Daco, principal economist at IHS, said. “There is no miracle solution the Fed can pull out of its hat and make the economy better all of a sudden.”
This week's market rallies on Tuesday and Wednesday were widely attributed to investors’ hopes that Bernanke will announce a new monetary stimulus. They may be OK without any major announcements. Bernanke just needs to signal that the Fed will do what it takes to ensure that the United States avoids another recession, Behravesh said. That’s what markets want to hear.
But simply signaling that the Fed is standing by to help may not be enough. “If investors are pricing in the fact that the Fed holds this miracle solution, this Houdini rabbit-out-of-the-hat act,” there could be a negative market reaction if Bernanke fails to announce any substantial action, Daco warned.
Bernanke may try to inject some positivity even if he doesn’t announce action. “I think he’ll say 'We’re not that worried about inflation. We’re not that worried about the recovery,’ ” Behravesh said.
In the end, Sweet said, “I think it’s important to keep in mind that Friday’s event is still just a speech.”