Should the Fed Buy Stocks to Boost the Markets?

When Fed Chairman Ben Bernanke convenes the annual summer retreat of global central bankers and economists in Jackson Hole, Wyoming on Friday, he'll have a lot more on his mind than the breathtaking scenery. The economy has proved to be a bigger headache than anyone imagined, and the Fed doesn't seem to have a ready answer about what to do next.

"The Fed is largely out of bullets," says Joel Naroff, president of Holland, Penn.-based Naroff Economic Advisors.

Not so, says Roger E.A. Farmer, chairman of the economics department at the University of California at Los Angeles, who is the author of a new book on the financial crisis called, How the Economy Works.Farmer says the Fed's interest-rate setting Open Market Committee erred two weeks ago when it announced that it would maintain its bond portfolio at current levels instead of buying more securities -- a process known as quantitative easing that is designed to stimulate the economy.

"I don't think the Fed delivered a particularly positive message. I think the half-hearted attempt to continue with the current bond portfolio without increasing quantitative easing is disturbing," Farmer says.

Farmer would like the Fed to be "intervening in a big way in the asset markets," and he makes the novel suggestion that this include Fed purchases in the stock market, as a way to stabilize asset prices. While he acknowledges that is probably not politically feasible in the current political climate, Farmer would still like to see the Fed substantially expand its purchases of Treasury bonds.

Uncertainty Rules

In fact, the Fed's decision to maintain its bond portfolio at the current size, rather than allow it to shrink, did appear to affect bond prices. Interest rates have fallen to historic lows since the Fed meeting, which means investors benefited -- bond prices rise when interest rates decline. But stocks have fallen about 6% since the FOMC met.

"There is a huge amount of uncertainty out there about what is going to happen to stock prices in the future," Farmer says. Because huge amounts of capital are waiting on the sidelines to see what will happen, asset prices, house prices and real estate prices will continue to fall, he says.

Housing is one of Bernanke's biggest headaches. Existing home sales plummeted by 27% in July, while housing inventory increased from 8.9 months to 12.5 months. New home sales also plunged to the lowest level on record.

"The problem is that housing typically leads the economy out of a recession," says Naroff. "In this economy it's not going to do that. It's another factor that argues we're going to have a slow recovery."

Naroff says he still believes the country will escape a double-dip recession. But Farmer thinks that fate remains a distinct possibility, and David H. Resler, chief economist at Nomura Securities International, says he has raised the chances of a double-dip from one in four to four in ten in just the past two days.

"When you're at low rates of growth, it doesn't take much to tip the scales to negative," Resler says.

Resler anticipates the Commerce Department will announce on Friday that GDP growth in the second quarter was just 1.6%, down from 3.7% in the first quarter. Goldman Sachs is even more pessimistic, predicting only 1.1% GDP growth will be reported for Q1. Only a month ago, Bernanke told Congress that most members of the FOMC expect 3-3.5% growth in 2010 and 3.5-4.5% growth next year.

Fed Holding Steady, but Under Pressure

At its meeting on Aug. 10, the FOMC acknowledged that the pace of recovery "has slowed in recent months." It announced that it will keep constant the Fed's holdings of government securities at the current level, which is a whopping $2.3 trillion, three times greater than in 2008. As the mortgage-backed securities it owns mature, they will be rolled over into Treasuries.

As a sign of the difficulty Bernanke now faces in setting policy, The Wall Street Journal reported earlier this week that seven of the 17 voting members of the Fed committee had opposed keeping the Fed's portfolio of securities at its current size. Some conservatives on the FOMC wanted to reduce the size of the portfolio to avoid concern about stoking inflation, while liberals wanted more purchases to stimulate the economy.

"I suspect Bernanke is a lot more sympathetic to an expansionary view than a lot of other people on the committee," Farmer says. The Fed chairman can try to convince doubters of the wisdom of his views, but he is not a dictator, he adds.

Bernanke may have more headaches ahead. Resler says it is likely that unemployment, now at 9.5%, is likely to start rising again later in the year.

That's partly because many long-term unemployed, who left the labor market officially when jobless benefits were ended in June, have come back into the market to collect benefits that have been reinstated by Congress. They still won't have a job, but they will now be counted as jobless, which will put more pressure on Bernanke and the Fed to take dramatic action.