TIGHT MANEUVERING FOR BERNANKE / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

The Wall Street Journal

HEARD ON THE STREET

NOVEMBER 12, 2009, 5:00 P.M. ET

Tight Maneuvering for Bernanke

Ben Bernanke may be boxed in.

After going to extraordinary lengths to shore up the economy, the Federal Reserve's recent actions suggest it has a lot less room for maneuver than investors believe.

The Fed's loose monetary policy, executed through traditional means like cutting interest rates, but also through unorthodox measures like large purchases of securities, has reignited confidence in the economy. The soaring gold price and sinking dollar are conspicuous indicators of skepticism. Overall, though, markets back the Fed.

After rallying, the S&P 500-stock index is trading at 17 times forward operating earnings, the sort of above-average multiple that investors assign when they expect steady economic growth. And another important market looks optimistic. Mortgage-backed securities issued by Fannie Mae and Freddie Mac, the focus of the Fed's asset purchases, now have yields that are only slightly higher than Treasury yields. With only four months to go before the Fed is scheduled to end its purchases, it seems few investors in this market fear the central bank's exit.

But a real risk remains. As Mr. Bernanke cuts back stimulus, the economy could again sag. In that case, the Fed would be faced with a tough choice. It could reinstate asset purchases, damaging its credibility and making some markets more dependent on central-bank liquidity. Or it could stand its ground, and risk tipping the economy back into recession.

Certain economic data, like Thursday's jobless claims, suggest the economy may be able to find its footing after the Fed pulls back. Yet something as important as bank lending isn't only weak, it appears to be getting worse. In the past six months, a time of increasing economic optimism, total loans at commercial banks have fallen 6%. That is one reason why a monetary measure like M2 is more or less flat over the same period, an ominous sign, given the amount of money the Fed has printed.

Moreover, the Fed appears to be planning to reduce monetary stimulus far earlier than it might normally after a recession.

After the 2000-2001 slowdown, the Fed waited for a sustained drop in unemployment before raising rates, in 2004. The Fed isn't likely to increase rates anytime soon, but securities purchases are scheduled to end well before any sizable drop in unemployment. And because those purchases have added significantly to the monetary bang of low rates, stopping them could mean an effective tightening sooner than expected.

If there is an unexpectedly adverse reaction to Fed purchases ending, in Fannie and Freddie securities or beyond, it would leave the central bank in a bind. It would unveil just how dependent markets and the economy have become on emergency stimulus. And it would leave investors far more fearful of diving in behind the Fed, if it started buying again.

—Peter Eavis

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