Wednesday, August 10, 2011

More Jackson Hole Shock-and-Awe?

Ben Bernanke’s shocking FOMC announcement on Tuesday -- that its zero-interest-rate target would be extended for two more years through the middle of 2013 -- drove Dow stocks up over 400 points. But this new policy had no stock market carry-over on Wednesday, when the Dow plunged over 500 points.

But we have not heard the last from Ben Bernanke -- not by a long shot.

Buried in the last paragraph of this week’s surprise FOMC announcement was this huge statement: “The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability.”

This is a brand-new statement. And in all likelihood it was purposefully open-ended. A Fed source suggests that this sort of stuff is usually left out of sight and buried in Fed committee minutes, released well after the FOMC meeting, and not put boldly in the actual policy statement. So clearly, it’s very important.

What might it mean?

When Bernanke speaks at the Fed’s Jackson Hole, Wyoming, meeting on August 26, he could conceivably launch a real shock-and-awe stimulus program. If you go back a year, when Bernanke first announced QE2 at Jackson Hole, sources tell me that the original debate over the quantity of bond purchases had a $2 trillion balance-sheet expansion on the table. Inflation hawks beat that number back to $600 billion. But now the rest of that $2 trillion -- or $1.4 trillion -- could conceivably be on the table for a new QE3 announcement by the Fed.

A new round of Fed bond purchases would likely be aimed at pinning long-term interest rates down as much as possible. In other words, the Fed will be buying 10-year paper and maybe even 30-year paper to get those yields down even more (10-years are currently around 2 percent). The idea would be to reduce the attractiveness of government bonds and get investors into riskier assets like stocks, or perhaps even new-business and venture-capital start-ups where potential yields look even more attractive. There may even be some job-creation in all this.

Plus, the Fed’s potential Jackson Hole shock-and-awe program could include the removal of the 25-basis-point Fed payment on the $1.6 trillion excess bank reserve now on deposit at the central bank. If the banks no longer earn a safe 25 basis points, they might conceivably lend more.

And if long-term rates come down as per Bernanke’s target bond purchases, mortgage rates might come down even more to the benefit of future and current homeowners.

Politically, inside the Fed, three regional bank presidents dissented from the unprecedented Fed decision to keep its target rate down for two more years. But the inner circle of Fed power -- Ben Bernanke, Janet Yellen, and William Dudley -- has enough votes from other Fed board governors and reserve-bank presidents to jam through almost any shock-an-awe it wants. All this could be announced formally at the next Fed meeting on September 20, but Bernanke himself is likely to let the cat out of the bag in Jackson Hole toward the end of this month.

The trouble with all this is that it didn’t work the last time with QE2, and it will have no permanent effect on the slumping economy. Targeting bond yields and printing more money simply distorts asset prices throughout the financial markets. We’ve seen this movie before. And it didn’t play well. The Fed’s shock-and-awe risks another round of dollar depreciation. It’s part of the message of skyrocketing gold prices right now.

Unleashing dormant animal spirits in this economy can only come from the fiscal side, with low-tax and regulatory reforms to provide new economic-growth incentives and lower the cost of doing business. A pro-growth package from Washington is what we really need. It should be part of the next round of budget cuts, included in the work of the super committee during phase two of the debt deal.

Without those new incentives for growth, the Fed can print all the new money in the world and the federal government can spend itself into oblivion, and none of it will resurrect the economy.