For the third time in a little more than ten years Wall Street has embraced a dubious narrative to drive the market higher in the face of crumbling fundamentals. In early 2000 the conventional wisdom discarded over a hundred years of valuation history in denying that the market was in a bubble driven by speculation in internet-related stocks. In late 2007 investors again drove the market to a peak, insisting that the subprime mortgage problem was just too insignificant to impact either the economy or the market. And if anything did go wrong, the good old Fed was there to ensure that the worst outcome would be a so-called "soft landing". In both cases the economy went into a recession and the market dropped more than 50%.
Now, once again the economy is struggling, and investors are depending on the Fed’s impending announcement of QE2 to bail them out, driving up the market in anticipation of the news. That the economy is deteriorating is obvious. If not, QE2 would not even be under discussion. The problem, though, is that after TARP, the stimulus plan, Fed purchases of $1.7 trillion in mortgages and Treasuries, near-zero interest rates, cash for clunkers, homebuyer tax credits, mortgage remodifications and unemployment insurance extensions, there is little more that the Fed can do that they haven’t already done. The Board has used all of its conventional tools and some not so conventional, and now is in the position of entering into a great experiment with unknown outcomes and possible unintended consequences. The truth is that the Fed cannot use monetary policy to force companies, banks and consumers to take credit that they do not want.
The problem was well presented in an August op-ed column in the Wall Street Journal by Alan Blinder, a former Fed vice-chairman and colleague of Ben Bernanke at Princeton. The article, called "The Fed is Running Out of Ammo", outlined three options for the Fed—-expanding the Fed’s sheet further, changing the "extended period" language in the Fed’s statement or lowering the interest rate on bank reserves. He then demonstrated that each of these options had negative political consequences, economic drawbacks or limited effectiveness. He concluded by saying that if the economy didn’t pick up, it would be time to use even this "weak ammunition", although he obviously didn’t think it would be of much help.
Blinder is a main-stream economist, and we doubt that his views differ much from the majority of the FOMC. They must know that they are about to implement a policy that has never been tried before on this scale and that the outcome is extremely uncertain. However, with the White House and Congress in gridlock, the Fed knows that they are the only game in town. What they are hoping to do is increase the Fed’s balance sheet, induce the banks to extend a lot more credit, lower long-term interest rates, spark spending by consumers and business and raise the inflation rate, which they regard as too low.