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Fed! Bond Buying! These Words Spark Pavlovian Market Rally

The Huffington Post  |  By Mark Gongloff  |  Posted: 03/ 7/2012 1:34 pm Updated: 03/ 7/2012 1:58 pm

Bernanke

Just how addicted is the stock market to the Fed's easy money? We just got a prime example.

Late Wednesday morning, stocks were meandering along, not doing much, still licking their wounds from their worst selloff of the year on Tuesday.

Then The Wall Street Journal posted on its web site a new story from its top Fed reporter, Jon Hilsenrath, and the stock market took off like a rocket, with the Dow Jones Industrial Average jumping nearly 80 points in a few minutes.

Up high in the story were the words "Fed" and "bond-buying." The market immediately assumed this meant Fed Chairman Ben Bernanke was just about to fire up his money helicopter for a third time, launching a fresh round of "quantitative easing," which is fancy talk for printing a boatload of money to blow all over the place.

In the first two rounds of QE, the Fed used the extra cash to buy Treasury bonds and mortgages from banks. That pumped money into the financial system, which in turn pumped the stock market up by several thousand points, which has magically created jobs for all. Or something like that.

The market has been pining for QE3 for months now and thought it got a hint of this Third Coming in today's WSJ story.

Trouble is, the story said nothing of the sort, really.

But the stock market is sort of like your dog -- if it hears the word "treat" or "walk," the context doesn't matter. It immediately assumes it is about to get a treat or a walk.

And the market has been conditioned to immediately start drooling, wagging its tail and shaking violently when it hears the words "bond buying" coming out of Ben Bernanke's mouth or Jon Hilsenrath's keyboard.

The truth of Hilsenrath's story is more boring -- sterile, even. It looks like the Fed is going to spend some of its policy meeting scheduled for next week talking about whether to put a new weapon in its arsenal, something called sterilized bond buying.

What is "sterilized bond buying," you ask? This means the Fed would print money to buy Treasury bonds and mortgages, just as it did in its first two rounds of bond purchases, QE1 and QE2.

Except this time, it will "sterilize" these bond purchases by taking the cash it prints right back from the banks and tying it up for short periods of time.

The idea of tying up the money is to keep inflation, or worries of inflation, from getting out of control, because there'd be less cash around to drive up the costs of gasoline, cotton or what have you.

If all of this sounds unnecessarily complicated to you, well, then you win the Nobel Prize for economics, because it is.

If the Fed's primary goal is to avert another Great Depression, or at least a deflationary spiral where prices never stop falling, causing long-term economic growth to stay constantly depressed, then generating inflation is exactly what the Fed should be trying to do. Sterilizing purchases to keep inflation expectations low is self-defeating.

Anyway, as Hilsenrath stresses high in the story, the Fed has no plans to do any bond buying any time soon.

The economic data haven't been terrible lately, and everybody expects a decent jobs report on Friday. That means the Fed doesn't have a lot of cover to start printing more money right now, particularly in an election season when everybody wants to hate on the Fed, and even some Fed officials are skeptical that more bond purchases are needed. If the Fed's forecasts for the economy come true, and it avoids a recession, then it will think it has no need for more bond-buying.

Of course, the Fed is not, shall we say, especially good at economic forecasting. So it's going to take some pretty good economic data to convince the stock market that QE3 is not coming.

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