Why Is the Market Miffed by a Prudent Fed Intervention?

New doubt has been cast on the effectiveness of the Federal Reserve's expected monetary expansion campaign that will probably be announced next week. This morning, the Wall Street Journal reported that a new asset buying program is likely to be small and slow. Investors weren't amused, as the news is blamed for most of the reason why the stock market is down more than 1% today. Is their response rational?

First, let's look at precisely what the Journal article said:

The central bank is likely to unveil a program of U.S. Treasury bond purchases worth a few hundred billion dollars over several months, a measured approach in contrast to purchases of nearly $2 trillion it unveiled during the financial crisis. The announcement is expected to be made at the conclusion of a two-day meeting of its policy-making committee next Wednesday.

That's obviously a little vague, but it sounds like we're talking between $250 and $500 billion to occur over three to six months. Why is the market unhappy with that?

In the economy's current condition, it's impossible to justify a massive $2 trillion asset purchase plan. When the financial crisis hit, such a program made sense for two reasons. First, the economy was on a very bad trajectory, as several quarters of steep drops in GDP were imminent. Second, the asset-backed bond market was frozen, so the Fed needed to purchase securities in order to provide banks with funding to continue to lend.

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Now, we have two very different problems. The first is high unemployment. It's a big problem, but there's no guarantee that an asset purchase plan will have much of an effect on jobs anyway. You can provide a banker with capital, but you can't make him lend. If consumer demand remains low, then businesses might fail to take advantage of ultra-cheap credit. That's certainly been the prevailing narrative over the past several months.

The second problem is low inflation. Yet the mere mention of more quantitative easing appears to have already done its work on this front. It's not likely you need to print $2 trillion to keep inflation from sinking further. A few hundred billion dollars should do the trick.

But most importantly, the economy isn't in nearly as grim a state of affairs now as it was during the financial crisis. The recovery is painfully slow, but it's a recovery. GDP continues to grow little-by-little, some companies have started hiring, and others have stopped firing. It's just going to take some time for consumers and businesses to feel comfortable enough again that strong demand returns. A little Fed intervention may help, but a lot could overshoot. By exercising prudence, the Fed should accomplish its goal while maintaining the flexibility to change course if necessary.

There are also some rumors today that the Fed might not announce more quantitative easing next week at all. A source from a Dow Jones article says:

"It would not surprise us if they don't do it at all," said Greg Salvaggio, vice president of capital markets at Tempus Consulting in Washington, pointing to pressure from some members of the Group of 20 industrialized and developing economies for the Fed to refrain from taking action that could have the knock-on effect of weakening the dollar.

It should surprise him, and everyone else, if the Fed doesn't act. At this point, it has more or less already committed itself to monetary expansion. Several top Fed officials have called for a quantitative easing effort, including Fed Chief Ben Bernanke. The G20 isn't going to change that, because these central bankers are already beyond the point of no return. If the Fed fails to act, investors would no longer trust its officials, worrying that they may be crying wolf when discussing planned policy. The Fed won't risk losing the power of its communication.