By Steven Russolillo and John Shipman
Wall Street loves to play the expectations game. Now, it looks like the Federal Reserve is getting in on the action, and how it fares could have troubling consequences, not the least of which concerns the already battered U.S. dollar.
Ever since the Fed put the prospect of QE2 on the table, the stock market, along with Treasurys and a string of commodities, have been riding a one-way ticket higher, all at the expense of the dollar. All other factors have been put on the back burner. Earnings, economic data, breadth, valuation, sentiment, none of them matter nearly as much as the Fed’s potential to flood the financial system with more easy cash. Inflation expectations have taken the ride as well.
What seems clear is the Fed “has already begun a passive easing of monetary policy well before the actual QE2 has been implemented,” said David Beckworth, assistant economics professor at Texas State University. “Because future economic activity influences present economic activity, the Fed is already influencing current aggregate spending by altering expectations.”
But what if the FOMC in early November doesn’t announce it’s engaging in QE2? What if the committee acknowledges that the economy is still muddling along, but recent indicators suggest just enough pickup in economic activity to not warrant additional easing, for the time being?
That could certainly send short-term shock waves through markets, especially considering the high expectations for QE2. The historic September rally — based largely on QE2 coming to fruition — could go up in smoke, but maybe that’s a small price the Fed is willing to play.
The idea isn’t completely crazy. Richard Fisher, head of the Federal Reserve Bank of Dallas, mounted another strong attack against the notion that Fed intervention will solve the economy’s problems.
“While none of us are satisfied with the current pace of economic expansion and job creation, presently it is not clear that conditions warrant further crisis-like deployment of the Fed’s arsenal,” Fisher said.
It all comes back to expectations. If the Fed can keep investors convinced that QE2 is still on the table, and it’s not afraid to fire up the engines at the appropriate time, then it can keep playing this expectations game. The longer the Fed can go without showing its hand, the more time it buys, with the hope that the economy will improve enough on its own that it never will have to lay its cards on the table.
It’s a delicate dance, but managing expectations may be the best hand the Fed can play right now.