Federal Reserve policymakers must be pleased with themselves. Market participants have fallen in line like lemmings off a cliff pursuing the obvious trades as the excitement over quantitative easing builds. Equities, bonds, commodities are all up. Dollar is down. Perhaps more importantly, measured inflation expectations have trended higher. Psychology is a powerful thing. Like leverage.
But like leverage, psychology can turn against you. The psychology of market participants forms on the back of expectations, which in this case is for the Fed to announce a significant expansion of the balance sheet on November 3. If the Wall Street Journal is correct, the Fed is poised to disappoint those expectations with an announcement of "a few billion dollars over several months." This looks like a clear effort to temper expectations.
How can Federal Reserve Chairman Ben Bernanke not view this as anything but yet another major policy error? The first supposedly "shock and awe" balance sheet expansion failed to reflate the economy. What kind of expectations should we have for the "shock and disappoint" strategy? And the stakes are even greater. Market participants already dutifully followed the first reflation attempt, and have eagerly embraced the second. Just exactly how many bites at the apple does Bernanke expect he is going to get? Fool me once….
Moreover, the Fed's communication strategy will almost certainly become more muddled in future months. A reminder from the Wall Street Journal:
In the next few months, internal opposition to Mr. Bernanke's approach could intensify as presidents of three regional Fed banks who have expressed skepticism about the plan—Narayana Kocherlakota of Minneapolis, Richard Fisher of Dallas and Charles Plosser of Philadelphia—take voting positions on the Fed's policy-making body.
To be sure, Fed policymakers will argue that they are trying to preserve flexibility. Why is it that "flexibility" means the ability to scale up? Why can't "flexibility" mean the ability to scale down? Seriously, it is not as if the Fed is in any danger of hitting either of the objectives in the dual mandate anytime soon. And does Bernanke really believe that it will be any easier to offer a credible commitment to scale up once Dallas Federal Reserve Chairman Richard Fisher is a voting member of the FOMC?
And to what extent does a smaller than anticipated QE reflect a concern about a precipitous fall in the Dollar? Is this part of the G20 "agreement" to end currency battles? Taking currency effects off the table will greatly reduce the effectiveness of any QE strategy. Does Bernanke expect to win this battle on expectations alone, without actually having to live up to those expectations?
Bottom Line: Right now, I have more questions than answers. The US economy is operating below potential to the tune of about a trillion dollars give or take. The Obama Administration is poised to turn its attention to deficit reduction, seemingly oblivious to the historical errors of Japanese fiscal policy, not to mention the US experience in the Great Depression. For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. Truly, it boggles the mind, and suggests that Bernanke is far more worried about the specter of inflation than the real pain of unemployment.
