Why the Fed Will Intervene If Stocks Fall Too Far

Why the Fed Will Intervene If Stocks Fall Too Far 8 hours ago Investors looking for more Federal Reserve intervention can pretty much ignore the economic data and train their sights on one area: the stock market, and how much of a drop it will take before the central bank comes to the rescue.

Though the recent market selloff is worrisome, it could take as much as a 10 percent drop or more before the Fed acts.

While central bank action ostensibly is geared toward using monetary policy to control the levers of prices and employment, the era of quantitative easing has brought with it increased focus on how the equity markets push the economy, and not the other way around.

As such, Chairman Ben Bernanke and his fellow Fed officials will be paying great attention to whether the sharp stock decline Wednesday, as well as the market's generally lackluster performance the past three weeks, signals a need for more stimulus.

"Mr. Bernanke and (former Fed chair Alan) Greenspan made it clear that the stock market is the transmission mechanism for monetary policy," said Quincy Krosby, chief market strategist at Prudential Annuities in Newark, N.J. "They know that a stronger stock market feeds into a stronger economy, which feeds into investor confidence.

"It is an underpinning for that all-important virtuous cycle that Mr. Bernanke and all economists talk about."

Major indexes shed more than 1 percent the day after minutes from the most recent Fed Open Market Committee meeting indicated significant hesitation toward a third round of easing.

While most of the economic data has been on an upward slope, investors remain nervous over whether the market can stand on its own. Since the financial crisis, the Fed has expanded its balance sheet to nearly $2.9 trillion with bond buying that has helped spur liquidity.

Pinpointing how much the market would need to drop is a difficult exercise, but Krosby said it probably would take something approaching a full-blown correction - or 10 percent drop - before the Fed would step in.

"If the data weakens and begins rolling over, it will reflect in the market and show a repeat of 2011. The Fed is cognizant of that and their time frame for action is very narrow," she said. "A 5 percent pullback now - that goes under the rubric of consolidation and you would have more buyers come back in."

More than that, though, and the Fed is likely to use the lessons of the past two rounds of quantitative easing and take action, which likely would come in the form of $1 trillion or so of mortgage bond purchases.

"When QE1 has ended, when QE2 has ended, basically the stock market has gone down by 1,500 points the next month or two," Bill Gross, co-CEO of bond giant Pimco, said in a CNBC interview. "Is the Fed trapped in this conundrum of providing cheaper liquidity in order to pump up the stock market and risk markets? I think they are. I won't argue...whether it's good policy, but it's necessarily policy based on where central banks have led us."

Gross, too, did not speculate on how much of a drop it would take, but previous Fed actions provide some clues.

The second round of QE followed a 15 percent summer stock swoon, and after Bernanke telegraphed the move in a speech he gave at the annual Jackson Hole, Wyo., summit in late August 2010.

Implementation of QE1 in November 2008 came after a much steeper decline, after markets lost about 40 percent during the height of the financial crisis.

The Fed followed the end of QE2 last year with Operation Twist, a balance-sheet-neutral move in which it sold shorter-dated debt and bought longer maturities. The program was aimed at driving down interest rates, but has coincided with a sharp stock market rally.

"Equity markets around the world didn't take too well to the prospect that the Fed is set to remove the punchbowl - and with good reason. The recent bout of risk-on investing, as we had predicted, is predicated purely and simply on the success of quantitative easing and the prospect of more in the coming months," Andrew Wilkinson, chief economic strategist at Miller Tabak in New York, said in a note to clients. Wilkinson sees possible intervention coming, but believes it could be a painful period for investors with a likely "slide in equities to help recalibrate the reality of where the global economy really stands."

"The message from the Fed's minutes could harshly be interpreted that from here, investors are on their own," he said. "What we had hoped was that such a message would be very apparent to consumers, homeowners and investors who just couldn't wait to race away from the starting tape.

Instead it looks like the economy faces a long, hard crawl."

Why the Fed has taken QE3 off the agenda

by Gavyn Davies April 3, 2011 The minutes of the Federal Open Market Committee meeting on March 13 have surprised the markets. The committee seems to have shifted in a markedly more hawkish direction than was reflected in the statement issued after the meeting, and the bar to quantitative easing 3 now seems to be rather high. Perhaps we should have expected this, given the fact that speeches by chairman Ben Bernanke and Bill Dudley since the meeting had given no hint of any further easing. But the breadth of the committee’s shift away from easing was certainly not expected.

It is easy to find hawkish phrases in the minutes. The US Federal Reserve staff has not only upgraded its real gross domestic product projections, and increased its inflation forecasts, but has also reduced its estimate of the output gap. Only “a couple” of FOMC members saw any case for further easing, and then only if growth falters or inflation falls below target. There was even some discussion of changing the guidance on keeping short rates “exceptionally low” up to the end of 2014, a move which would really shock markets.

Nevertheless, it would be very premature to conclude that the Fed is close to tightening policy.

Much of the debate revolves around the recent behaviour of the labour market, where Mr Bernanke still seems to be on the dovish end of the spectrum.

In January, the Fed chairman stoked expectations that QE3 may be just around the corner when he said the following: “If recovery continues to be modest and progress on unemployment very slow, and if inflation appears to be likely to be below target for a number of years out – so the configuration we’re talking about in the projections – then I think there would be a very strong case, based on our framework, for finding a different – additional tools for expansionary policies or to support the economy.”

In an important speech last month, Mr Bernanke again concluded firmly that cyclical unemployment is far too high. But, significantly, he did not suggest that there was still a “very

strong case” for “additional tools” to support the economy. He is probably biding his time, waiting for clearer evidence from the labour market that more action is needed.

There are three areas of uncertainty in the labour market which the Fed will be watching carefully.

1. Okun’s law As noted here, the most recent decline in unemployment has been faster than would have been expected, given the reported rate of growth in real GDP. The chairman focused on this in his recent speech, saying that the abnormally large decline in unemployment in 2011-12 was simply a reversal of the enormous shake-out of labour, relative to GDP, seen in the depths of the 2009 recession. He is right about this.

The first graph shows the results of some recent work by Zach Pandl of Goldman Sachs, which estimates the difference between the level which unemployment should have reached, given the behaviour of GDP, and the level it actually did reach. The labour shake-out in 2009 is very clear, as is the “shake-in” in recent quarters. If the GS work is right, then unemployment is now back to normal, and should not drop any further unless GDP accelerates to an above-trend rate. The implication of this, if it is confirmed by upcoming data, is dovish for policy.

2. The Beveridge curve The relationship between unemployment and vacancies is called the Beveridge curve. Since both of these variables measure labour market slack, they should be inversely related to each other in a

fairly predictable manner: higher unemployment should imply fewer vacancies, and vice-versa.

However, in the current recession, unfilled vacancies have been stubbornly higher than they “should� be, given the level of the unemployment rate. (The Beveridge curve, shown below, has therefore moved out to the right.) This suggests that companies may be struggling to find suitable workers to fill the available jobs in the economy, in which case the labour market is tighter than would be implied by the unemployment figures.

Mr Bernanke considered this possibility, but suggested that vacancies may be taking some time to adjust to the severity of the recession, while unemployment has risen more rapidly owing to the dramatic rise in lay-offs during the recession. If so, vacancies should soon start to fall, and the Beveridge curve will move back to its normal place. If this happens, the implication would be dovish.

However, it must be said that this is taking an awfully long time to happen, if it is going to happen at all. Peter Newland of Barclays Capital, from whom the above graphs are taken, suggests that we may be seeing a repeat of the 1970s economic cycle, in which the outward shift in the Beveridge curve was never reversed during the subsequent economic recovery. The structural level of unemployment had therefore risen permanently, with hawkish implications for monetary policy. This will be watched carefully by the Fed.

3. The labour force participation rate Since 2008, there has been a rapid decline in labor force participation, which now seems to have been mainly due to the ageing of the labour force, rather than to the rise in disaffected workers who cannot find a job during the current recession. This implies that many people may have left the labour force permanently, and therefore that they will not be available to boost the labour supply if the economy recovers further. The last graph shows the results of a recent study by the Chicago Fed, which concludes that demography has already reduced the trend participation rate significantly and will do so much more in the next few years. The implication of this, if it happens, is hawkish, since it reinforces the Fed’s worries that the output gap may have declined.

So where does all this leave us? With wage inflation still very low, the FOMC members seem most unlikely to jump to the conclusion that excess unemployment has now been eliminated. Nor should they. But, in their minds at least, the case for QE3 in the near term seems to have evaporated.

Zeitgeist: Addendum MOVIE BELOW http://www.youtube.com/watch?v=1gKX9TWRyfs

END THE FED THEIR A BUNCH OF CROOKS !!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!