Where we stand: the Fed in delicate balance

It is now two weeks since the election results in Europe gave markets a pause and investors a reason to reconsider risk exposures from new, lower levels.

Notwithstanding the worries out of Europe, the US economy appears to have entered a period of slow, but steady improvement. 
Certainly the performance of US banking sector stocks seems to be reflecting this, up more than 10% ytd in absolute terms (as well as versus the SPX), despite the recent market selloff and JPM story impact. And with relatively healthy behavior from the banks, it would seem unlikely that the overall market is set to tank.

On the policy front, the Fed finds itself in delicate balance. On the one hand, there is still lack of confidence regarding the sustainability of the recovery, coupled with the real possibility of significant fiscal drag kicking in towards year-end.

Meanwhile, measures of inflation and inflation expectations have been trending lower, giving the ‘doves’ room to argue for additional easing measures.

Bloomberg reports:

With six weeks left before the end of the Fed’s $400 billion swap of short-term debt for longer-term securities in a program known as Operation Twist, everything from yields on securities that protect against rising consumer prices to a measure of the outlook for inflation in the forwards market show diminished concerns. Traders are pricing in a 55 percent chance that the central bank will begin new efforts to spur economic growth, Bank of America Corp. says.

For first time since it announced Operation Twist in September, the Fed’s preferred gauge of measuring traders’ inflation expectations is poised to fall for a second straight month.

“Growth concerns have increased, and with the drop in commodity prices inflation concerns have decreased which has kept the environment friendly for low rates,” said Michael Pond, co-head of interest-rate strategy in New York at Barclays Plc, one of the Fed’s 21 primary dealers. “If growth stalls, the employment rate stops falling and inflation remains no concern, it won’t take much for another round of stimulus.”

The difference in yields between 10-year notes and Treasury Inflation Protected Securities, or TIPS, which represents traders’ expectations for the rate of inflation over the life of the bonds, fell to 2.04 percentage points on May 17. That’s the least since Jan. 23, and down from the high this year of 2.45 percentage points on March 20.

“We’ll probably have to go below 2 percent on 10-year break-evens for the Fed to say there’s a higher chance of deflation priced in,” Priya Misra, head of U.S. rates strategy at primary dealer Bank of America Merrill Lynch in New York, said in a May 14 telephone interview. ”This paves the way for more stimulus, but we’re not there yet.”

Adding to the debate on the desirability of further monetary stimulus is the risk of political backlash, especially from the Republicans.

What is more, there are voices within the Fed that have long expressed their unease with additional rounds of accommodation. Most notably, Dallas Fed president Richard Fisher, highlighting the associated ‘moral hazard’ issue vis-à-vis the fiscal authorities.

Back in September 2011, Bloomberg reported:

“If I believe further accommodation or some jujitsu with the yield curve will do the trick and ignite sustainable aggregate demand, I will support it,” Fisher said today in a speech in Dallas. “But the bar for such action remains very high for me until the fiscal authorities do their job, just as we have done ours. And if they do, further monetary accommodation may not even be necessary.”

                                                   

“I am wary of adopting any policy that might have the unintended consequence of becoming a veterinary fix rather than a more salutary repairing of the ability to propagate jobs,” he said.

A similar line of argument has been echoed by Philadelphia Fed president Charles Plosser in his article in the Financial Times, citing the issue of central bank independence. 

Today, Atlanta Fed president Lockhart also set the bar 'high' for additional asset purchases by the Fed.

My view is that the Fed, led by Bernanke, remains fundamentally open to further stimulus and alert should the economy take a turn for the worse. Certainly, the fact that measures of inflation and inflation expectations have been moving lower also renders potential Fed action more ‘justifiable’.

In addition, the risk of a ‘Euro accident’ may force the Fed’s hand in order to ‘fight’ the upward pressure on the dollar. 

Danger of a euro collapse, albeit temporary, is clearly on the minds of most central bankers nowadays; Mervyn King’s response during the recent Quarterly Inflation Report Q&A session is indicative:

Journalist:  …you did say then that there's substantial devaluation of rates. But what happens – we know markets tend to overreact. Supposing the pound just goes on up and up and up? Is your policy to continue to be one of non-intervention?

Mervyn King: Well, that's a question which is a perfectly reasonable question to ask, but it's one I will answer if and when it happens and not as a hypothetical question. But I'm very pleased to see someone here who remembers the days of trade deficits and the problems that can result from that.

Extreme circumstances open the door for extreme measures.