Market Talk

Does helicopter Ben have something up his sleeve?

US stocks looking to extend their weekly gains on Wednesday, as a slew of corporate earnings is taking a backseat to Fed Chairman Ben Bernanke’s Congressional testimony later this afternoon.

Speculation has been swirling about what measures the Fed may announce to stimulate growth, especially as chatter of the economy double-dipping back into recession keep increasing. Even though it’s unlikely Bernanke will announce anything substantial in his semi-annual testimony before Congress, the prospect of additional support for the economy has helped lift the major averages more than 1% this week.

“There is hope that the Fed will ride in again on its white horse and save the day,” David Carter, chief investment officer at Lenox Advisors, told me yesterday. But he cautioned that potential further loosening of monetary policy or other any other moves by the Fed could have negative long-term implications.

But does the Fed even have a white horse to ride in on anymore? There’s a growing sense that there’s only so much the central bank can do to prop up the stock market and, subsequently, the overall economy. Miller Tabak equity strategist Peter Boockvar hit the nail on the head in his morning commentary today:

What everyone watching must ask is has the law of diminishing returns set in with the actions of the Fed. I believe yes.

It’s a great point and one that has us reflecting on the Fed’s first major interest rate cut during the financial crisis. In January 2008, the Fed instituted a surprise rate cut, slashing its overnight lending rate by 75 basis points to 3.5%, in a move intended to help prevent the economy from falling into a recession.

The stock market rallied initially on the news, but the positive vibe proved to be short-term, and, as with the other rate cuts, a pattern ensued. Stocks seemed to always react positively to the Fed’s moves at first, but as time went on, the euphoria over an interest-rate cut started ebbing sooner and sooner. With interest rates now effectively at zero, contemplating the Fed’s next move and wondering whether the law of diminishing returns has set in is definitely a valid question.

Former Fed governor Larry Meyer and former Fed economist Antulio Bomfim offer on the Macroadvisers blog several suggested questions for Bernanke in his Congressional testimony today. They’d like Bernanke to address several topics including: probability of a double dip; Fed concerns about deflation as well as any plan to resume quantitative easing and if so, what are the options. Here’s their kicker: “Do you worry about the adverse and potentially dangerous consequences of keeping rates so low for a very long time?”

While many believe the Fed may be running out of ammo, especially with interest rates effectively at zero, PIMCO’s CEO Mohamed El-Erian offers five options Bernanke could institute if additional policy actions are needed to prop up the economy:

Hyper time extend the “exceptionally low for an extended period” interest rate signal; push banks to lend more by cutting the interest it pays on reserves; directly extend loans to certain segments of the non-financial economy; resume asset purchases; and cap interest rates.

To be sure, El-Erian doesn’t expect anything drastic to come from Bernanke’s two-day testimony.

“He will likely try to reassure us on the direction of the economy (yes weak, but recovery is slowly taking hold), remind us of what the Fed has already done, and stress the institution’s vigilance should additional policy measures be needed,” El-Erian says.