Bernanke Hints at Further Fed Intervention

The odds that the U.S. Federal Reserve will engage in further economic stimulus increased dramatically following Fed Chair Ben Bernanke’s testimony before Congress’ Joint Economic Committee Tuesday morning. Despite protestations that there are no “immediate” plans for a third round of quantitative easing (“QEIII”, if you will) the Chairman did not close the door to further quantitative easing if necessary:

The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.

Currency markets responded immediately to Bernanke’s remarks with investors taking the view that further easing was now probable. The potential that another round of stimulus spending could weaken the dollar helped the euro reverse its slide against the buck which had been riding high on risk aversion fears that Greece would be forced to default. In the past two weeks, the dollar gained more than 10 percent, climbing to a high of $1.3144 to the Euro before the Chairman’s comments prompted investors to sell the dollar.

Operation Twist

During his testimony, Bernanke expanded on his expectations for Operation Twist – the Fed’s scheme introduced last month whereby the Fed intends to sell short-term securities to finance the purchase of longer-term bonds. The hope is that this will lead to lower yields on long-term securities thus reducing their attraction to investors. The idea is that this money will then find its way into the economy rather then be left sitting on the sidelines in long-dated bonds.

The Fed has stated that Operation Twist should lead to a 20 basis point decline in long-term interest rates which, according to Bernanke, will have the same stimulus impact of a half percentage decrease to the Federal Funds Rate. The more cynical observer may dispute this assessment but with interest rates already reduced to zero, the Fed has limited options available.

Outlook Downgraded

While Bernanke was keeping his cards close to the vest during much of his testimony, he did admit that the Federal Reserve’s outlook has turned more pessimistic in recent months:

However, the incoming data suggest that other, more persistent factors also continue to restrain the pace of recovery. Consequently, the Federal Open Market Committee (FOMC) now expects a somewhat slower pace of economic growth over coming quarters than it did at the time of the June meeting, when Committee participants most recently submitted economic forecasts.

It remains to be seen if this downgraded outlook will be sufficient to convince the Fed to undertake another round of quantitative easing.

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