After deploying its heavy artillery to battle the Great Recession, the Federal Reserve appears to lack the shock and awe ammo many in the markets may be hoping for to fend off a double-dip recession.
However, instead of a major rescue like QE3, many Fed watchers believe Ben Bernanke's central bank will use Tuesdays highly-anticipated meeting to acknowledge the economys serious headaches and unveil just incremental steps.
Those steps could include more clearly spelling out how long interest rates will remain low, expanding the scope of its extended period language to cover its balance sheet and extending maturity dates on its securities portfolio.
Fed Toolbox Depleted
They will open the door to some type of symbolic easing action, said David Jones, president of DMJ Advisors and a former Fed economist. Theyre not going to give us QE3.
Since the Fed last met on June 22, the Dow has plummeted 1,300 points in response to signs the U.S. economy could contract, fears about Europes scary sovereign debt crisis and last weekends unprecedented credit downgrade by Standard & Poors.
The selling, which was highlighted by Mondays 635-point, or 5.55%, plunge on the Dow, has ratcheted up the pressure on the Bernanke-led Fed.
When youre faced with a major crisis, the only institution that can really be a backstop is the central bank, because only the central bank can create money out of thin air, said Jones.
However, during the 2008 financial crisis the Fed already lowered its key interest rate to the extraordinarily low level of 0% to 0.25% and took the unconventional steps of buying trillions of dollars of securities through QE1 and QE2. With its main tools already deployed, the Fed appears to be left with little ammo to fix the current crisis.
While we think that the Fed will have to respond to evidence of a slowing of the U.S. economy, it is simply running out of policy levers to pull, analysts at Brown Brothers Harriman wrote in a note.
Quantitative Easing Criticized
Fed watchers believe Bernanke is unlikely to kick off QE3 at this meeting, unless he actually believes the U.S. is set to suffer a double-dip recession. While recent indicators have been very troubling, consensus economic forecasts still see two consecutive quarters of negative growth -- the technical definition of a double-dip -- as significantly less than a 50/50 proposition.
The other reason why QE3 is probably not in the cards right now is because the earlier program was highly unpopular. Sure, it sent riskier assets like equities surging. But that buying binge came at a heavy cost.
The negative sides of QE2 probably outweigh the positives, said Jones. By causing the U.S. dollar to significantly lose value, QE2, caused massive bubbles in asset prices, including oil, which in turn killed consumer spending.
At the same time, many believe the law of diminishing effects dictates that QE3 would have a much lighter impact on already-low interest rates. In a classic flight to safety, the yield on the 10-year Treasury fell on Monday to 2.339% -- the lowest level since January 2009. The yield on the 2-year bond slid to 0.256%, unchartered territory since 1973.
We've now seen the wreckage that followed after [QE2] ended on June 30th, the entire QE2 equity rally has almost reversed," Peter Boockvar, equity strategist at Miller Tabak wrote in a note. "Here lies the fallacy with any short-term stimulus, either monetary or fiscal. At some point it has to end and then we revert back to where we were, with then a bill to pay either through higher taxes or from the eventual exit of policy.
Smaller Tools on the Table
Calling QE3 unlikely unless the economy falls back into recession, Goldman Sachs (NYSE:GS) predicted the Fed will instead on Tuesday expand the scope of its extended period language to cover not just low rates, but also the central banks incredibly large balance sheet.
At a later date, the Fed is also likely to shift its composition of its balance sheet toward longer maturities of either mortgage backed securities or Treasurys, Goldman predicted.
The Fed may also use the meeting as an opportunity to be more precise about how long rates will stay extraordinarily low. Goldman believes an exit date for easy-money policies will be pushed back to as late as the end of 2014.
Jones said policy makers could lower the interest rate on bank deposits to 0% from 0.25%, but he called that not strong enough action.
Its also possible the Fed will announce a less-talked about move, such as a new mechanism to help beaten-down Europe or even buying corporate debt.
However, jumping into another asset class could be risky. You cant underestimate the negative impact that going beyond normal central practices has here, said Jones.
Given the Feds dwindling ammo and the intensifying crisis in Europe, traders hoping for a central bank rescue may want to set their sights on the other side of the Atlantic.
If any central bank needs to act in a big way to deal with this global financial meltdown, maybe its time for the ECB to act, said Jones.