By Steven K. Beckner

(MNI) – Panic? Or just precaution?

Take your choice of “P” words, but there’s no question Federal
Reserve Chairman Ben Bernanke and all but one of his fellow policymakers
took a calculated risk in deciding to go in for what amounts to some
additional monetary stimulus at their Aug. 10 Federal Open Market
Committee meeting.

In deciding not to allow the natural shrinkage of the central
bank’s balance sheet that otherwise would have taken place, the FOMC was
basically announcing to all the world that it has lost confidence in the
economic recovery. It was not only signaling that the downside risks to
economic growth have intensified, but also, implicitly, that
deflationary threats have worsened.

It’s a doleful admission.

Although the immediate, somewhat surprised, market reaction was
largely favorable, only time will tell how the FOMC’s decision affects
investor and consumer confidence and behavior — and how inflation
expectations will be impacted.

If the Fed is worried enough about the economy to swing from talk
of exit strategy to purchasing more bonds, one might well ask, then what
does that say about the outlook for investing, for hiring, for pricing
and so forth?

Bernanke, ever the activist student of the Great Depression, was
not satisified merely to ask his colleagues to maintain the status quo.

The FOMC has been saying for months that it would “continue to
monitor the economic outlook and financial developments and will employ
its policy tools as necessary to promote economic recovery and price
stability.” And Bernanke told Congress last month in his Monetary Policy
Report that, given an “unusually uncertain” outlook, “we remain prepared
to take further policy actions as needed to foster a return to full
utilization of our nation’s productive potential in a context of price
stability.”

Bernanke, in fact, told the Senate Banking Committee on July 21,
that one option the FOMC would be considering, was reinvesting the
proceeds of maturing mortgage backed securities in Treasury securities,
which is what has now been done — and in a relative hurry.

In a matter of a very short time, he has led the FOMC from the mere
hint of possible additional stimulus to rather assertive action. It’s
fairly striking in the annals of U.S. monetary policy. It’s the kind of
thing that became customary during the depths of the financial crisis,
but until very recently, the tack being taken by Bernanke and his
colleagues was a desire for normalization.

Now, an apparently alarmed Fed has taken a modest but still
substantial step back into crisis mode.

With Kansas City Federal Reserve Bank President Thomas Hoenig
dissenting even more emhpatically than he has before, the FOMC kept the
federal funds rate near zero and renewed its pledge to keep the key
overnight rate “exceptionally low … for an extended period.”

But that’s not all. Since halting its purchases of mortgage backed
securities to pull down long-term interest rates in March, most of the
talk has been about when the Fed might start selling those assets and
raising rates. It has not been reinvesting the proceeds of maturing
mortgage bonds, thereby permitting a shrinkage of the Fed’s balance
sheet and the amount of bank reserves.

Now, the Fed says it will reinvest the proceeds of those maturing
mortgage bonds in Treasury securities to prevent any such shrinkage.

“To help support the economic recovery in a context of price
stability, the Committee will keep constant the Federal Reserve’s
holdings of securities at their current level by reinvesting principal
payments from agency debt and agency mortgage-backed securities in
longer-term Treasury securities,” the Fed said in its policy
announcement.

“The Committee will continue to roll over the Federal Reserve’s
holdings of Treasury securities as they mature,” it added.

After the FOMC announcement was released, the New York Federal
Reserve Bank issued its own statement, declaring that the open market
trading desk will seek to maintain the value of outright holdings of
domestic sedcurities at around $2.054 trillion — the amount held as of
Aug. 4.

“In the middle of each month, the Desk will publish a tentative
schedule of purchase operations expected to take place through the
middle of the following month, as well as the anticipated total amount
of purchases to be conducted over that period,” said the New York Fed.
“The anticipated total amount of purchases will be calibrated to offset
the amount of principal payments from agency debt and agency MBS
expected to be received over that period.”

The New York Fed said “the Desk will concentrate its purchases in
the 2- to 10-year sector of the nominal Treasury curve, although
purchases will occur across the nominal Treasury coupon and TIPS yield
curves.”

“The Desk will typically refrain from purchasing securities for
which there is heightened demand or of which the SOMA already holds
large concentrations,” it said.

Explaining its decision, the Fed says “the pace of recovery in
output and employment has slowed in recent months.”

Though not dramatic, the impact of the FOMC decision is hardly
inconsequential.

Back in March, Brian Sack, head of the New York Fed’s Open Market
Trading Desk, estimated that $200 billion in agency MBS will mature or
be repaid by the end of 2011, and another $140 billion of Treasury
securities in the Fed’s portfolio will mature.

By preventing the System Open Market Account, and in turn bank
reserves, from being drawn down the Fed is not merely preventing a
monetary tightening by default, it is arguably effectively easing
policy, at least relative to market expectations.

More significant than the sheer amount of the net new Treasury
purchases which this even-keeling policy will yield, though, is its
potential psychological impact on market participants and the broader
public.

Last week this reporter posed the following questions which FOMC
members would need to ask: “Does the FOMC really want to send a signal
of alarm about the economy’s prospects at this point? Does it really
want to risk aggravating deflation fears and destabilizing inflation
expectations and price stability in a downward direction? ”

And, given the fiscal policy implications, this reporter asked,
“Does it want to also appear to be trying to accommodate record Treasury
borrowing more than it already is by holding interest rates near zero?
So close to an election?”

At a time when the fate of the Bush tax cuts, which are due to
expire one minute after midnight on Dec. 31, is unclear, one might also
have asked whether the FOMC’s action to stop MBS from running off is
intended to compensate for letting those tax cuts run off?

Hoenig this time not only dissented against the “extended period”
language. The statement also records that “given economic and financial
conditions, Mr. Hoenig did not believe that keeping constant the size of
the Federal Reserve’s holdings of longer-term securities at their
current level was required to support a return to the Committee’s policy
objectives.”

Clearly, though, Bernanke and the majority were not content to let
the recovery just run its course in wake of recent data, which include a
deceleration of second quarter GDP growth to 2.4%, a 131,000 July drop
in non-farm payrolls and other discouraging indicators.

Whether this turns out to be a wise move remains to be seen. One
suspects it could become subject to some major second-guessing,
depending on how economic and financial conditions — in particular
inflation expectations — unfold.

What makes Tuesday’s action a bit surprising is that Bernanke
couched the actual implementation of additional stimulus measures in
terms of fairly dire economic circumstances in last month’s
congressional testimony. And he did not significantly change his
rhetoric in a speech just over a week ago.

“Further policy stimulus might become appropriate if the outlook
were to worsen appreciably,” he said on July 21. And after observing
that “monetary policy is currently very stimulative,” he said “if the
recovery seems to be faltering then we will at least need to review our
options.”

Has the economy “worsened appreciably?” Is the recovery
“faltering?”

The Fed seems to be telling us just that. Plan accordingly.

** Market News International Washington Bureau: 202-371-2121 **

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