Fed Trapped By Inflation
There will be NO announcement of QE 3 tomorrow. Why? Because the Fed has trapped itself into a corner. The first two rounds of Quantitative Easing (QE1 and 2) were viable for the Fed as inflation was running at deflationary levels in 2009 and at the bottom of their target range of 1-3% in 2010.
In both instances the implementation of asset purchase programs, which immediately juiced liquidity in the financial markets, had an immediate and pronounced effect on the level of inflation.
Today, with inflation currently approaching 4% on a year-over-year basis the Fed is not only outside its inflation mandate of 1-3% but any further cost pressures on the consumer is going to drive the economy into a recession. As we showed recently in our post on 3rd quarter GDP with food and energy consumer more than 23% of wages and salaries there is very little wiggle room for the average American.
Without access to credit, declining incomes on a year-over-year basis and uncertainty about employment there is tremendous strain on the consumer to make ends meet. The Fed knows this. They also know that without help from somewhere the economy is in trouble. The hope is that they can "talk" the markets along.
Therefore, expect no announcement of QE 3 tomorrow but lots of talk about policy tools, potential for further action and another punt to current Administration. However, there is a bigger problem brewing, and one that has been set aside due to the issues with Greece, the "Super Committee" only has 22 days left to announce the spending reduction plans before the automatic cuts take hold. This won't be good.
Unfortunately for Ben, and the Fed, they are trapped between the need to "do something" to boost the financial markets and support the economy but are constrained by their mandates to keep inflationary pressures under control. There is no help coming from a deeply divided Administration that can find no middle ground to compromise on. Furthermore, the automatic spending cuts are going to sap a portion of the 23% of personal incomes that are made up of government transfers. The consumer is tapped out, the economy is much weaker than the headline numbers suggest and without liquidity assistance from the Fed you can expect the recession to take hold in 2012.
However, we might get surprised by the Fed as they have done it before. The real question is even if they do something will it be enough to offset the damage that has already been done.