Don't rule out Fed 'shock and awe'

By Paul R. La Monica, editor at large


NEW YORK (CNNMoney.com) -- According to the Chinese calendar, next year will be the year of the rabbit. But for the Federal Reserve, 2011 is shaping up to be the year of the hawk -- the inflation hawk, that is.

That may be a reason why the Fed announces a significant quantitative easing plan after it wraps up its two-day meeting this Wednesday. The central bank is widely expected to unveil a new round of asset purchases, which investors and economists are dubbing QE2.

paul_lamonica_morning_buzz2.jpg

The goal is to keep long-term interest rates low in order to stimulate more lending and borrowing. As such, the Fed will probably disclose plans to buy more long-term Treasuries. But there are questions about how big the program will be and how long the Fed will commit to keeping those purchases going.

In the past week, investors have started to fret that QE2 will not be as bold as once thought -- the proverbial shock and awe. But some experts think Fed chairman Ben Bernanke may still act aggressively.

Three regional Fed presidents who are widely considered to be fairly vigilant about inflation risks -- Charles Plosser of the Philadelphia Fed, the Dallas Fed's Richard Fisher and Narayana Kocherlakota of the Minneapolis Fed -- will become voting members on the Federal Open Market Committee at the Fed's first 2011 meeting.

Because of the looming changes at the Fed, Burt White, chief investment officer with LPL Financial in Boston. said he would not be surprised if the Fed announced it will buy $250 billion to $300 billion in assets immediately.

White added the Fed would likely leave the door open for more purchases in coming months.

"The plan could be front-end loaded," White said. "With 2011 being the year of the hawk, the Fed has to take a big bite now. It needs more shock now."

There is also speculation the Fed may act with central banks of other developed nations on a broader easing plan. The Bank of England and European Central Bank are also holding policy meetings this week and the Bank of Japan moved up its next meeting, originally scheduled for mid-November, to this week.

"There is always the prospect of a coordinated global effort. That's definitely a possibility," said Daniel Hwang, senior market strategist for FOREX.com, a currency trading firm based in Bedminster, N.J.

Hwang said he expects the Fed to announce plans to buy $500 billion in assets over six months and that it will not rule out more purchases after that. That could bring the final price tag to at least $1 trillion before QE2 is complete.

The Fed could probably justify that much spending since inflation is not a problem yet -- as the chart at the top of this column clearly shows.

In fact, the Fed has specifically said that a goal of more easing is to return inflation to levels that are more consistent with a healthy economy.

Bernanke in particular seems cognizant of worries that inaction by the Fed could lead to the United States falling into a deflationary spiral like Japan in the 1990s.

"The Fed has been sitting there with short-term rates near zero and has already expanded the balance sheet and neither has had much of an impact," said Dan North, economist for the Americas region with Euler Hermes, a credit insurer in Owings Mills, Md.

"It's possible the Fed could err on the side of something bolder. The big risk is psychological -- that people think the Fed is not doing enough," North added.

The problem though is some fear too much easing could create out-of-control inflation fairly quickly. So Bernanke should probably expect Plosser and Fisher, who both voted at various times in 2008 against the Fed's decision to cut rates, to not be in favor of even more stimulus.

There is no voting track record for Kocherlakota since he was only named head of the Minneapolis Fed last year. But in recent speeches, he has said more easing may have a "muted effect" on interest rates.

Of course, it's not as if Bernanke won't have other so-called dovish-minded Fed members on the committee who would back his plans to do whatever it takes to stimulate the economy. And the Fed doesn't need a unanimous vote to act.

Still, many experts say that any hint of a fractured Fed could be problematic since it may send the signal to the financial markets that there is no clear consensus about where the economy is heading and what the best course of action is for managing monetary policy.

That's all the more reason for the Fed to move more pragmatically now. As long as the economy is growing in 2011, even if it's at a sluggish pace, the inflation hawks are likely to grow more worried about the risks of too much easing.

"Bernanke is going to have to deal with the possibility of more than one dissent next year. Some of the regional presidents are increasingly vocal and visible about easing," said Stuart Hoffman, chief economist with PNC Financial Services in Pittsburgh. "But by January, QE2 could be half done."

- The opinions expressed in this commentary are solely those of Paul R. La Monica. Other than Time Warner, the parent of CNNMoney.com, and Abbott Laboratories, La Monica does not own positions in any individual stocks.  To top of page

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