Initial reports of Friday’s stock market surge suggest that market participants were reassured by Fed Chairman Ben Bernanke’s vague pledge to consider the “range of tools that could be used to provide additional monetary stimulus.” I disagree with that assessment, but more on that below.
First, let’s take a closer look at Bernanke’s toolbox. I see only two tools. The first is interest rates. By keeping rates at effectively zero, I think it’s fair to say the Fed chairman has already used that tool; he simply can’t accomplish much with any further tweaks to rates.
The second tool I see is the Fed’s balance sheet. Whether Bernanke prints money, makes large-scale asset purchases or extends credits to banks, it all ultimately is an expansion of its balance sheet. Before the recession the Fed’s balance sheet stood at around $700 billion to $800 billion; after the Fed’s bond-buying program (QE1), assets at ballooned to about $1.7 trillion. Because the economic recovery was so fragile, Bernanke announced QE2 last November, adding another $600 billion to its now over—$2 trillion balance sheet.
Many commentators believe our current weakness shows the failure of quantitative easing, while others argue that catastrophe would have resulted had Bernanke not relaxed monetary policy. I am not arguing either viewpoint here. I am only suggesting that the effectiveness of any further easing must be in serious doubt; we simply lack the financial credibility to so.
The best measure of our credibility is the dollar, which used to buy 1.25 Swiss francs in 2007 but is now worth just 0.81 Swiss francs. The dollar might still be green and have George Washington’s picture on it, but—psychologically—further easing will make it feel more like an Argentine peso.
In short, I don’t think the Fed really has tools anymore; it’s left with just diplomacy—a polite way of saying that it can only bluff. But as any poker player knows, the ability to bluff is also a perishable asset if used too often.
When the Fed announced earlier this month, in the face of persistent economic weakness, that it would keep its benchmark rate at near zero till mid-2013, it was an admission that a) it can’t use its rate tool and b) it can no longer expand its balance sheet in any meaningful way; it therefore conferred an aggressive calendrical blessing on U.S. investors.