Political Constraints Provide Insight On Fed Policy

by: Evan Schnidman

On Tuesday, July 31 Bloomberg News reported that 88 percent of the economists it surveyed said the Fed would not announce another round of asset purchases on August 1. Of the economists polled, 26 percent said they did expect another round of asset purchases in the near future with most saying that the next round of QE will involve at least some purchases of mortgage-backed securities. This report is extremely troubling because it indicates that at least one quarter of the economists in the Bloomberg survey are out of touch with political reality. This is an election year and despite proclamations of Fed independence, Bernanke and the rest of the FOMC clearly have no interest wading into the election season and looking like they are playing favorites by initiating stimulus in the months before a presidential election.

The trouble is that something needs to be done to keep the economy moving in the right direction. While some commentators have said that any stimulus on August 1 would be "pre-emptive," they seem to forget that monetary policy takes time to have real effects on the economy. Perhaps more pressing in the eyes of a committee that fiercely guards its independence, if they wait any longer it will be politically dangerous to act until the December FOMC meeting. So, once we account for the political constraints, it is much more likely that the FOMC will announce a policy change this week.

To be very clear, just because we expect to see a policy change does not mean we should be expecting QE3. Inflation is just high enough to keep QE3 from being the preferred choice by the committee and once we account for the incredible political backlash this would prompt, it is highly unlikely that the actions will be QE3. Most commentators seem to assume that most likely alternative is that the committee will do nothing or simply extend the low rates pledge beyond 2014. This is a simplistic view that does not account for the other policy options at the Fed's disposal.

As critics of Fed policies have recently noted, despite increasing liquidity, some of the Fed's existing policies create barriers or disincentivize lending. The simplest fix (and one the media has begun to latch onto) is that the Fed could lower rates it pays out on excess reserves; this would increase incentives for bank to lend this capital, but Chairman Bernanke has expressed reservations about the effect this might have on the functioning of short-term money markets. Given these downside risks and the fact that the Chairman has also expressed a clear interest in the Bank of England's "Funding for Lending" program, it would make sense for the Fed to move in this direction. The policy might not overtly be announced Wednesday, but the FOMC will likely announce a new partnership with the Treasury to construct the policy and work out the legal details over the next few weeks. In order to satisfy fears over increased policy complexity, the Fed might very well announce additional transparency or communication measures as well.

Many will read this prospective unfolding of events as the Fed stalling or doing nothing, but a program comparable with the "Funding for Lending" program is definitely stimulative and carries less downside risk to financials than does a rate cut on excess reserves. Still, this policy will take time to have dramatic effects on the market, so look for the bigger market mover this week to be the ECB announcement. Any indication that Draghi can make good on his recent promises will be a huge boost to equity markets and to the euro.

The bottom line is that investors should not expect QE3 in August, September or October. In its place, the Fed will likely attempt to promote lending with politically safer options like lowering rates on excess reserves or by engaging in something comparable to Funding for Lending.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.