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Fed Fireworks in 2011?

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This week the Federal Open Market Committee (FOMC) meets in its last regularly scheduled meeting for 2010. It's important to note this meeting marks the first opportunity for FOMC members to discuss formally the implementation of QE2 since its announcement on November 19.

With only a few weeks having gone by since that meeting, one would think the FOMC is unlikely to have sufficient information to warrant major changes from the previously announced strategy.

Recent better than expected numbers consumer confidence (per Barclays consumer attitudes are at their highest level since early 2008) and initial jobless claims (lowest 4-week average since August 2008) will no doubt be on the Fed Governor's minds.

Solid retail sales and producer prices announced this morning will certainly factor into the debate at the FOMC as well. The latest unemployment numbers (Non farm payrolls) announced earlier this month -- an increase from 9.6 percent to 9.8 percent -- will also be of concern.

QE2 in 2011?

My friends at DC Tripwire anticipate much more debate about amending the Fed's mandate to focus solely on price stability, with many Fed critics expressing nervousness about the Fed's ability to deliver on the current dual mandate of price stability and full employment.

At the same time, some economists, including the former head of the Council of Economic Advisers under President Bush, Greg Mankiw, argue that the Fed's current policy would not likely be different under a price stability mandate, given that inflation numbers remain below FOMC desired levels.

Those with an eye on the stock and bond markets should know the new year will begin with the release of the FOMC December 14 meeting minutes on Tuesday, January 4, 2011. This release will provide further insights as to what the FOMC members are looking for as signs of success or lack thereof on QE2.

Four new members will join the FOMC for the two-day meeting scheduled for January 25-26. Scrutiny of the Federal Reserve will continue as the New Year begins. As DC Tripwire has previously noted, some of these new members have expressed concern about QE2.

Thomas M. Hoenig, the president of the Federal Reserve Bank of Kansas City, has been a leader of the Bernanke skeptic camp. He's not a fan of aggressive use of experimental drugs like QE1 and 2. According to the New York Times, he says he believes the Fed's tools for fixing the economy in the short run are limited and the potential for things to go disastrously wrong is very high. To him, Bernanke's plan is "a dangerous gamble" and "a bargain with the devil."

The New Congress and the Fed

With the beginning of the new Congress in January 2011, strong Fed critics will have heightened visibility and authority. Representative Ron Paul (R-TX) assumes the leadership of the Domestic Monetary Policy Subcommittee of House Financial Services. The "End the Fed" author is expected to pose some interesting questions for the Fed. In addition, up and coming and influential GOP stars like Representative Paul Ryan (R-WI), slated as the House Budget Committee Chairman, spoke recently at a joint FreedomWorks-Atlas Foundation event on Capitol Hill, voicing his concerns about prior Fed policies.

Is our capitalist republic becoming massively over politicized?

I think the Gorilla in the room a lot of people are missing is the coordination -- or lack thereof -- between the Fed and Congress. If you remember Bernanke first floated the idea of QE2 in August and has been defending it ever since. He's even taken the debate right to the American people by appearing recently on 60 Minutes. Some people I know privately have joked that Ben has reached out to Barbara Walters and Whoopi Goldberg for a surprise appearance on The View.

As I stated in my last blog, Bernanke reached out to member of congress a few weeks ago and set up a private meeting with Senators and Congressmen who had been critical of the Fed in the national press. If you remember as QE2 was being implemented in mid November there were very aggressive critics in Congress of the Fed and Bernanke.

How did the Fed and Bernanke respond to these critics? In that private meeting my friends at DC Tripwire tell me Bernanke fired back, guns a' blazin'. In essence, he said, "you guys and gals of Capitol Hill have not done enough to get us out of this economic morass" and he warned if the Fed didn't act aggressively we would be looking at European style "structural unemployment" at elevated levels for years to come.

Fast forward to last week's aggressive, almost Reaganesque supply side tax cuts and stimulus embedded in the extension of the Bush Tax cuts. A bold agreement forged by President Obama and Congressional leaders. Some people call it "Stealth Stimulus" with estimates of $900 billion over 2 years in the extension of the Bush Tax Cuts, a healthy Payroll tax cut, extension of unemployment benefits, and juicy accelerated depreciation for small businesses.

The $64 billion questions are; was the Fed Expecting All this New Fiscal Stimulus? Did Bernanke scare Congress into an overreaction after months of their inaction? Is our capitalist republic becoming massively over politicized?

How did the markets react?

Smart asset managers tell me there's growing chatter, because of the creative innovations tax stimulus I listed above, the Fed will pull back on its expected $600 billion QE2 operations? The selloff last week in Treasuries was no doubt the largest in years. If you look at the yield on the 10 Year Treasury, over the last 12 months, you have a high of 4 percent, a low of 2.33 percent and an average of 3.21 percent (about where we are today). Much of this move back to the mean was achieved in the last 8 weeks. If you look at 30-yr mortgage rates were near 4.20 percent in late Oct / early Nov and today stand at about 4.74 percent. I thought QE2 was supposed to keep rates lower?

There's is no question we are entering a new era of Treasury price volatility. This increasing volatility in commodities and treasuries is shaking up P&L at Hedge Funds and Banks. I'm telling you, I was there as a trader at a large investment bank taking a lot of mark to market risk every day. This type of volatility creates huge balance sheet headaches for banks and hedge funds. The MOVE index from Merrill Lynch, which measures volatility in Treasury prices, has risen from 75 in August to 109 today. The sharpest move higher in years, no pun intended.

Last week, after the announced extension of tax cuts and stealth stimulus motivated Barclays and others to raise their 1Q 2011 real GDP estimates from 2.5 percent to 3.5 percent and full year '2011 GDP from 2.8 to 3.1 percent.

Be careful what you wish for Mr. Bernanke.