Analysis: Bernanke leaves investors mulling QE3 odds
NEW YORK (Reuters) – Ben Bernanke put markets on notice this week: Despite already having spent trillions of dollars to stimulate growth, the Federal Reserve would do more if inflation falls too far and the threat of deflation grows.
Bond investors are taking the Fed chairman at his word. If things get worse, some predict the central bank will go beyond targeting interest rates and move straight to outright buying of mortgage securities, municipal debt and even stocks.
“When I think of the Fed I think everything is on the table until it isn’t,” said Eric Green, chief economist and head of interest rate strategy at TD Securities in New York.
If the economy appears on the verge of deflation, the Fed will “have to go very big and be very creative, and that means munis are on the table, mortgage-backed securities, corporate (bonds), equities,” he said. “Everything is possible because the Fed has broken new ground and they will continue to do so if they feel they have to, exit strategy be damned.”
The Fed has pushed short-term interest rates to record lows and last week announced it would attempt to push down long-term rates by selling $400 billion of short-dated Treasuries to buy an equal amount of debt with maturities of seven years and up, in a policy dubbed “Operation Twist.”
This was designed to help the housing market by lowering long-term borrowing costs. It would also encourage investors to sell Treasuries for higher-yielding assets, which should boost stocks and corporate profits, encourage hiring and investment and provide a jolt to consumer sentiment and prices.
THEORY AND REALITY
That, at least, is the theory.
But fear that the economy may already be in recession has been pushing down stocks, commodities and Treasury yields for several months. U.S. stocks are more than 10 percent weaker since the start of August.
As a result, market expectations for U.S. inflation have retreated to levels last seen in September 2010, shortly before the Fed began a $600 billion bond buying program, the second installment of a policy known as quantitative easing, or QE.
When asked about this after a speech on Thursday, Bernanke said, “if inflation falls too low or inflation expectations fall too low, that would be something we would have to respond to because we do not want deflation.
The expected rate of inflation over the next 10 years as measured by the gap between Treasury inflation-protected securities (TIPS) and cash government bonds fell as low as 1.70 percent last week. At 1.83 percent on Thursday, it was still below the Fed’s unofficial inflation target around 2 percent.
St. Louis Fed President James Bullard chimed
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