Figuring Out the Fed: What Will Bernanke Do?

If after reading about or watching Federal Reserve Chairman Ben Bernanke's testimony on Capitol Hill this week, you couldn't figure out what the Fed is going to do next, you're not the only one.

Many on Wall Street and in Washington circles were left feeling the same way as the at-times Solomonic, at-times judicious Bernanke adroitly navigated his way through lawmakers' questions, using a case study or two to illustrate a point here, or a clarification and short-response to dismiss a flawed argument there.

Candid, and Appropriately Opaque, Testimony

On the one hand, Bernanke was candid. The Fed chairman stated, in so many words, that the central bank's data confirms that the U.S. economic expansion has slowed, with low inflation and a labor market that's healing too slowly.

Equally significant, the uneven and complex nature of the current recovery has led to an economic outlook that Bernanke termed "unusually uncertain," and he underscored that the uncertainty requires the Fed to be ready to take further actions if the U.S. economy either slows substantially or accelerates too quickly and boosts inflation.

On the other hand, Bernanke was traditionally -- and appropriately -- opaque. After quickly and substantively refuting any notions that the Fed has "run out of ammunition," he deftly avoided giving any hint about potential Fed policy actions, or non-actions. And the reason is obvious enough: Sensed Fed intentions -- let alone Fed actions -- have the potential to move hundreds of billions of dollars in international capital in minutes.

Fed Remains Ready to Act, Either Way

However, Bernanke's appropriate opaqueness is not to suggest that the Fed will not act, if economic and/or financial conditions warrant it. The Fed will move, if conditions justify further action, and history shows that the outlook for the U.S. economy is unlikely to remain "unusually uncertain" for more than a quarter or two. With the above in mind, here's a review of the Fed's options if the economy accelerates or slows.

Most investors are aware of the monetary-tightening scenario, should the U.S. economy suddenly -- and unexpectedly -- accelerate to a near-Chinese-level GDP growth with rising inflation. If that occurs, look for a faster increase in short-term interest rates and (assuming the U.S. housing market has stabilized, with sales and median prices trending higher) the appropriate unwinding of the Fed's balance sheet, including the sale of mortgage-backed debt.

What are less well known are the Fed's options should the economic recovery slow further, putting upward pressure on the nation's already-high 9.5% unemployment rate and downward pressure on corporate revenue and earnings. The weapon historical used to fight such conditions, lower interest rates, is largely out of bullets: The Fed has already lowered short-term interest rates about as low as they can go.

A Boost to Smaller Businesses?

However, the Fed could broaden the scope of a current credit facility, or, if it deemed it appropriate, create a new credit facility to both free up more capital and encourage lenders to make more loans.

For example, two problem areas concern credit to small- and medium-sized businesses and auto loans. The Fed could create new facilities designed to buy specific bank loans to those business, and/or buy auto loan debt. Each would free up capital for new loans to businesses and auto dealerships, and encourage lenders to make more such loans.

If history is any indicator, the impact on U.S. GDP of more credit to these small- and medium-sized companies could be substantial, particularly if hundreds of thousands of small businesses suddenly started hiring because they received a previously-denied business loan they needed to expand their operation, or if 2010 vehicle sales increase by another 500,000 or so because dealerships are able to secure credit for prospective car and truck buyers.

Unconventional Options?

Finally, if needed, the Fed could try something novel to further grease the wheels of commerce. Bernanke has demonstrated he's willing to implement unconventional tactics -- quantitative easing -- to deal with an unconventional crisis.

And he may have to, if the U.S. economy continues to slow. That's because it appears the American people are applying an old axiom of U.S. Rep. Barney Frank to the Fed. Frank is famous for saying, "Congress's actions have averted an economic calamity, but the American people don't give you credit for averting something. You have to make things better."

Led by Bernanke, the Fed's actions also helped avert a calamity, but that's not enough. Bernanke will have to make things better.