Will the Fed Stimulate, Target, Get Explicit, Twist, or Swerve?

Whatever option it chooses, the market is watching and can be counted on to react

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Federal Reserve Chairman Ben Bernanke must yearn for a time when he can reside over a boring, uneventful monetary policy meeting. Unfortunately for the nation's top central banker, he won't get that sort of meeting this week. With unemployment stuck above 9% and job growth struggling, many want to see more aggressive action from the Fed. And the market expects it. What action might the monetary policy committee take this week?

More Stimulus

What would Wall Street really love to see? All of these stimulus-without-stimulus tactics might help nudge the economy in the right direction. But some additional asset purchases would be the Fed's most aggressive option. An additional round of quantitative easing would have the most dramatic effect on interest rates.

But here's the problem: not everyone on the Fed's committee is convinced that additional stimulus is a good idea. Some view hiring as being on the right course. Others worry that inflation is already at the Fed's target rate -- and additional stimulus could send it too high. So this is probably not the most likely action the Fed would take at this time.

An Inflation Target

We have heard Bernanke and others suggest that the Fed could adopt a specific inflation target. Both hawks and doves like this idea, but each group likes it for totally different reasons. Hawks think a target would force the Fed to concentrate on price stability and put it ahead of stimulus. Doves, however, realize that the target actually provides the Fed even more flexibility to affect a weak economy: the target is meant to assure investors that even if inflation is elevated for a short period, eventually the Fed will move it lower to maintain its target.

If you saw additional stimulus, then you might also see a target. It would serve as a way for the Fed to say, "Yes, we're taking some potentially inflationary measures, but don't worry about prices because here's where we intend to keep inflation over the long-term."

More Explicit Economic Triggers

Last month, the big news was that the Fed provided an explicit timeline for when they would begin to consider pushing down interest rates. In the meeting minutes, we learned that the committee also mulled basing those triggers on economic metrics -- like the employment rate -- instead of seemingly arbitrary dates. This would theoretically provide even greater certainty to the market.

That is, unless these economic targets are just as meaningless as time-based targets. The Fed's minutes also made clear that the committee reserved the right to change its mind. So more detailed wording is just, well, words. It wouldn't serve as a concrete, absolute trigger for when the Fed would move one way or the other. If the picture changes, then so could its words. As a result, this change might not do much to pacify the market.

"Operation Twist"

How can you lower interest rates without actually injecting any additional cash in the financial system? We could see the Fed sell some of its shorter-term securities and use the proceeds to buy longer-term securities. Since short-term interest rates are being held very low by investors already, this would free up some cash for the Fed to shift its portfolio towards longer-term securities and take those interest rates down further instead.

The interesting wrinkle here is whether the U.S. government would boost its issuance of longer-term Treasuries in response. Really, it should. While doing so would make the stimulus a little less effective, having more 10-year-plus debt out there would help to better stabilize the nation's borrowing, since it wouldn't have to roll over as much debt as often for that long period of time.

The Hawk Swerve

Finally, there's the possibility that the Fed does nothing. Don't count this possibility out. We already know that three voting members were against last month's relatively benign language tweak, because they worried about its potential effect on inflation. Every option listed above is more aggressive than that, which means it would be pretty surprising to see less than three voting members against all those options.

And yet, the market certainly expects the Fed to do something. In fact, some action has already been priced into the market. A CNBC poll found that 69% of financial market participants it surveyed believe that Operation Twist will be announced. Just 25%, however, see additional monetary stimulus being provided at this time. So if the Fed does nothing, it clearly risks upsetting the market. With this pressure to act, this week's meeting won't be dull.

Image Credit: REUTERS/Jonathan Ernst