It's been widely assumed that QE2 is the end of quantitative easing and that there will not be a QE3. Could the Federal Reserve be willing to risk the economy contracting as result of the Fed pulling back the punch bowl cold turkey, at the same time congress is doing major fiscal tightening? With the Federal Reserve buying nearly 70% of Treasury issuance do they expect to simply stop buying and still have successful auctions? I don't buy it. QE3 may not look like QE2, and it may not even be branded "QE" any #, but I think whatever the Federal Reserve calls what they're doing it will "walk and talk like a 'QE' duck." So what might it be?
I have a few thoughts about this. (Not surprising.) My first hunch is that they do some restructuring of their balance sheet in cooperation with the Treasury such that they extend the terms on shorter term T'Bills to longer terms. By converting their 1, 2, and maybe 3 year notes to 10+ years they reduce the strain on holding successful actions by reducing the need to refinance these notes as they come due over the next few years. Second, the Federal Reserve could to look for a way to write down their MBS holdings, thereby giving relief to the obliges. This would be a great back door way to give relief to the housing market and at the same time help to further repair banks and mortgage holders balance sheets. No doubt that would produce liquidity that would make its way into the economy. Last but not least, they have to find a way to motivate banks to push their reserves into the economy. Maybe they will stop paying interest on reserves.
Do you remember when Paulson, Geitner, and Bernanke dreamed up TARF and produced a three page document that sailed through congress in a few days to save the world financial system from ruin? My sense is that something is brewing that will be announced before QE2 wraps up and the debt ceiling needs to be raised. What they come up with will have to be sold to the financial markets and congress. It will have to include something from Congress on adjustments to entitlements and other spending in order for the whole package to be credible. It will be pitched, with the help of the President, as the best (only) way to save the Federal government from default. But it will also be sold as positive solution that will put America back on solid ground and lead to years of economic expansion.
If this happens, and the Federal Reserve and the Treasury can pull this off with the help of the President, I think Dow 16K is a real possibility!
