As September FOMC meeting approaches, it is worth thinking through what is coming. It seems that commentators are converging on the three main options. Lets consider them in turn.
1. Extend duration of holdings. This probably meets less political resistance vs. the balance sheet expansion and may succeed in bringing 10y rates even lower. However its impact is unclear. Over last few months excess reserves in the FED increased roughly by the amount of QE2. So banks are not willing to lend (i.e. they do not face liquidity constraint, they face risk constraint), taking risk free assets off their balance sheet will not accomplish much. In this scenario, expect risk markets to come off eventually. Same for gold - no money printing, no extra support for the asset with negative carry.
2. Reduce or eliminate a 0.25% interest rate the Fed currently is paying on excess reserves. Given Bernanke's notes on this option in his speech in Jackson Hole, I would consider this move unlikely. At the same time, I believe that interest rate reduction can be quite effective. Faced with zero returns, banks may be forced to buy other assets. This potentially moves almost $1.6 trl in excess reserves into other assets. Equities are the greatest beneficiary. Since this is not inflationary per ce, gold is unlikely to benefit.
3. Further change in language. Obviously the impact of that is hard to judge, until we see the exact change. General principal remains the same, unless extra money is put into risky assets, we do not expect much in terms of results.
I continue to believe that monetary transmission mechanism in the US is not functioning properly. Excess reserves at the FED is one manifestation of that. Recently floated idea on easing the process of mortgage refinancing would help to repair such mechanism as it will give the debtors access to lower rates. Interestingly the related noises are quieting down, so it seems Administration is backtracking on this one.