Why does everyone think the Fed will ride to the rescue?

I have consistently warned for the past few months that the Fed would pause before rushing into QE3. I reiterated this yesterday. Yet, somehow people came away from Ben Bernanke’s testimony before Congress yesterday thinking the Fed was going to crank up the QE3 keyboard strokes. It’s not going to happen.

Look at Bernanke’s prepared remarks:

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.

On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and, as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve’s balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the federal funds rate target. From that point on, changing the level or range of the federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments.

Translation: the Fed will pause to assess the economy before doing anything else. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date.

There is immense pressure on the Fed from within as well as politically to refrain from more unconventional policy. The economy will weaken significantly before the Fed moves against it – and only then because of vocal outcries for more policy stimulus.

Tim Duy sees this as well – and he wants more from the Fed. Bottom line: there will be no stimulus unless the economy and/or asset markets deteriorate further.