After 635-point sell-off, Fed running out of options

It's unlikely the Fed will introduce another round of quantitative easing, say some observers

By Patrick Allen, CNBC.com

The Dow fell by 635 points, Asia followed suit and Europe is expecting losses for up to 6 percent following the downgrade of US debt by ratings agency Standard & Poor’s. Whether the move by S&P can be wholly blamed for the heavy selling of stocks is open to question, but the market is now asking how the Fed will react when it meets today to discuss its response at its monthly meeting.

Last month, Federal Reserve Chairman Ben Bernanke outlined four actions he could take: More quantitative easing; cutting interest on excess reserves; buying longer-dated bonds, or giving guidance on when he will begin to shrink the Fed’s balance sheet. All options open to the Fed chairman, and following the huge losses for stocks since late last week, the Federal Open Market Committee will on Tuesday have to take all options very seriously.

“Judging from the experience with QE2, another round of asset-purchases might be the Fed’s best option to resuscitate the stock market in the short-term,” Harm Bandholz, the chief US economist at Unicredit Research, said in a note to clients following what he described as “Black Monday.”

Noting that stocks rallied by 30 percent following the announcement of QE2, Bandholz said he thinks it unlikely that the Fed will push the button on QE3 despite the sense of panic following the 635-point loss for the Dow on Monday.

“While it is possible that the Fed will embark on another round of asset-purchases in an attempt to calm financial markets, we do not think that such a step is particularly likely at the moment," he said.

Cutting interest on excess reserves would have little impact in Bandholz’s view, given that the rate is already very close to zero. That leaves only two options: buying longer dated bonds or giving guidance on the Fed’s plans for its balance sheet.

Others believe the chances of the Fed pulling the trigger on QE3 have fallen. “The odds of more QE have clearly shortened substantially, but on balance we think the FOMC will hold fire,” said Ian Shepherdson, the chief US economist at High Frequency Economics.

Both Bandholz and Shepherdson believe the Fed could try and extend the maturity structure of bond holdings or give guidance on the size of the balance sheet, but both also are skeptical that such moves would have much positive effect.

“They might bolster confidence -- and they basically come at zero costs,” said Bandholz, who likened such a move to the Kennedy Administration's Operation Twist.

“It could also announce an intention to restructure its portfolio, shifting out along the curve in order to flatten it, but we doubt this would have much effect in the real world…the problem in the US right now is not the level of long rates,” said Shepherdson, who believes a stimulus package would be the best option -- but something that is not going to happen in Washington's current political environment, where the conservative wing of the Republican party is strongly opposed to government spending.

“In order to remain optimistic about growth, then, you have to take the view that the impact of the drop in stock prices will be outweighed by the benefits of plunging energy prices and the return of bank balance sheet expansion," he said. "The combination is not impossible to imagine, but neither it is impossible to imagine it all going wrong.”