The Fed: their toolbox is bigger than yours.

Quotable

“I might at this point interject a little tidbit that typifies our government and Congress. The Pythagorean theorem consists of 24 words. Archimedes’ Principle is 67 words and the US government regulations for The Sale of Cabbage consists of 26,911 words!!”
                                          Adrian Krieg

Commentary & Analysis
The Fed: their toolbox is bigger than yours.

Perhaps the only words from the FOMC announcement yesterday which would not have led to a relief rally would have been:

We’re hiking rates by 50 basis points. Sorry.

Your esteemed leaders,

The FOMC

P.S. The US economy is toast.

I say this for two reasons: first, I think the markets were due for a breather; second, I think expectations were set in line with what was eventually delivered; third, I think the Fed carefully and effectively acknowledged – via low-rate pledge and rhetoric – the struggling US economy.

Most commentators were not yet expecting Bernanke & Co. would unleash a brand new bond-buying initiative (i.e. QE3). Most did believe the Fed would continue with its “low rates for an extended period” language – they did. Most were ready to buy at much more attractive “valuations”.

But perhaps the current (and future) difference-maker was the timeline … envisioning slow growth until 2013. This 2-year forecast adds a bit more seriousness to the situation. And while the low-rate pledge is supportive at this moment, I think it will need to be augmented by some other form of easing measures in order to keep investor sentiment from eroding.

In other words, look for this rally to peter out in a matter of days. A 1250 target on the S&P 500 seems like a reasonable topping point … as long as 1200 and 1230 don’t get in the way:

If it means anything to you, Goldman Sachs seems to agree. They now expect QE3 is more likely than not.

We now see a greater-than-even chance that the FOMC will resume quantitative easing later this year or in early 2012. We have changed our call because today’s statement suggests that the committee’s reaction function to incoming economic news is more dovish than we had previously thought. Although Fed officials still expect a gradual decline in the unemployment rate, they made a conditional commitment to keep the funds rate unchanged "at least through mid-2013" and implied that they would employ additional policy tools in case their economic forecast deteriorated further. This would probably mean more QE if their forecast converged to our own modal view of a flat-to-higher unemployment rate through the end of 2012, let alone our downside risk case of a renewed recession.

GS agrees with me; or I with them. And that’s all fine and dandy. But I ask again, as we have done many times in the pages of Currency Currents: will QE3 matter?

Consensus seems to agree that QE1 and QE2 failed to support the real economy but succeeded tremendously in supporting the financial economy and financial markets. I think the consensus also agrees that a QE3 won’t do anything to support the real economy this time around either.

And to me that represents a legitimate headwind to QE3’s potential effectiveness in propping up the financial markets this time around (i.e. investors realize this time that the economy is going to get worse) … as it did in rounds past.

What might impact this expectation for an all-around QE3 failure is the composition of QE3.

Both QE1 and QE2 consisted of large scale asset purchases (primarily government bonds). Yesterday’s FOMC statement suggested the Fed has multiple tools at its disposal. Of course, the credibility and effectiveness of these “tools” are immediately suspect … since the Fed hasn’t already pulled them from the toolbox. But the surprise factor might just be enough to bolster investor sentiment.

You know how the saying goes:

“Don’t’ fight the Fed” because their toolbox is bigger than yours.

Gold Futures and US Dollar Index Futures, daily: low rates until 2013?