Analysis: Fed may have bullets left, but are they blanks?

By Steven C. Johnson

NEW YORK (Reuters) - When Federal Reserve Chairman Ben Bernanke takes the podium next week at the central bank's annual meeting in Jackson Hole, Wyoming, his sense of deja vu may be overwhelming.

Stocks have been giving up gains won after last year's speech, when Bernanke hinted at plans to pump more money into the financial system. Oil prices are higher and there's been little improvement in the job market. Bond yields are down, though, because the economic outlook has deteriorated.

It's almost as if QE2, the Fed's $600 billion bond-buying program first mentioned at last year's meeting and designed to boost the struggling economy, never happened.

That's not to say investors doubt the central bank's resolve to act again if the U.S. economy keeps losing steam. Last week, it surprised markets with an unprecedented pledge to hold interest rates near zero until at least 2013.

But given questions about the efficacy of monetary stimulus to date and a growing political backlash against the Fed's policies, investors expect the U.S. central bank to keep its powder dry at this year's Jackson Hole symposium from August 25-27.

It's not that the central bank doesn't have a few tricks left up its sleeve. Bernanke has previously detailed what he could do next. This includes buying long-dated Treasuries to push down long-term rates and cutting interest on bank deposits held at the Fed to encourage more lending.

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Still, there's the problem of ever diminishing returns. The benchmark S&P 500 index rallied more than 4 percent when the Fed on August 9 said it would keep rates low into 2013, but fell more than 4 percent the next day. At around 1,200, the index is off its August 8 low but trading remains volatile.

Atlanta Fed President Dennis Lockhart has said the central bank could buy more long-term bonds to lengthen the duration of its portfolio, which would flatten the yield curve and allow homeowners to refinance at lower interest rates.

But with rates already low, the impact may be muted.

What's more, investors said lower 30-year bond yields could actually complicate life for insurance companies that have to match liabilities and assets.

POLITICAL BACKLASH

Then there's the limited impact the Fed's quantitative easing, or QE, has had on the broader economy, which ground to a halt in the second quarter and, some fear, is flirting with a slide back into recession.

Economists polled by Reuters now expect the economy to grow at just a 1.7 percent rate in 2011, well below the Fed's June forecasts of 2.7 to 2.9 percent.

Including QE2, which ended in June, the Fed has spent some $2.3 trillion in recent years to prevent a slide into deflation, more than tripling its balance sheet in the process.

That has put the Fed in the line of fire of some politicians and voters -- so much so that some investors fear the growing politicization of Fed policy could curb its independence.

Texas Governor Rick Perry, a Republican candidate for president, even said he would consider it "treasonous" if Bernanke "prints more money between now and the election" in 2012.

William Larkin, fixed income portfolio manager at Cabot Money Management, dismissed Perry's remarks as "crazy talk," but did say the Fed faced increased political hurdles.

"The Fed is going to face a lot of push back," he said. "Keeping rates low has caused talk of financial repression --- stealing from savers and giving to debtors."

A weaker dollar, partly the result of the Fed's easing, also complicates things. While it in theory helps exports, it also makes imported goods more costly, putting more pressure on consumers. Against major currencies, the dollar is 11 percent weaker since the August 2010 Jackson Hole meeting.

Support for more easing isn't universal within the central bank, either. Dallas Fed President Richard Fisher, one of three policymakers who voted against keeping interest rates low until 2013, blamed "fiscal malfeasance in Washington" for the economy's woes.

MAKING SENSE OF IT ALL

None of this makes investing any more straightforward, money managers say. While stocks still look more enticing than low-yielding Treasuries, many portfolio managers have grown more defensive given the worsening economic outlook.

Dickson said he recommends clients increase cash and metals allocations just to be safe. But he still favors stocks over bonds, particularly multinational stocks that offer dividend yields above the 10-year Treasury.

He said a D.A. Davidson & Co portfolio of such stocks has held up better than the S&P, shedding about half as much as the broader market between mid-July and August 8.

Another option for equities investors is high-yield corporate bonds that offer comparable returns but "half the volatility" of stocks, Shah said, noting U.S. corporations are sitting on piles of cash.

"But for people who want to preserve capital, there aren't a lot of choices," he said. "You're going to earn zero here."

There may be reason to hope that the Fed won't need to act again. The central bank's latest senior loan officer survey showed some easing in lending conditions, particularly for commercial and industrial loans to businesses.

If the trend persists, that could encourage more hiring.

Should things take a turn for the worse, though, investors had better bet on another round of QE, said Michael Cheah, senior portfolio manager at SunAmerica Asset Management in Jersey City, with $1.5 billion under management.

With inflation low and wage growth stagnant, he said the Fed has the leeway to pour more money into the system. That would boost stocks at the expense of bonds and stoke demand for higher-yielding currencies over the dollar.

"I think quantitative easing is only creating the illusion of prosperity but my job is to trade that illusion," he said. "That makes me bullish stocks."

(Additional reporting Burton Frierson; Editing by )