Don't Fight Bet On The Fed

The era of quasi-religious belief in "Don't fight the Fed" is drawing to a close; the Fed has been revealed as significantly less omnipotent and powerful than previously imagined.

Many observers expect the Federal Reserve to bail out the stock market next Tuesday with an announcement of QE3, another round of "monetary easing" to reinstall the trade in risk assets. If they do, it will fail. The basic reason it will fail is that the Fed's credibility has fallen below a critical threshold. Put another way, the quasi-religious trust in the Fed's infallibility and power to single-handedly reverse global markets has been eroded by reality: QE2 was a monumental failure.
 
Here's a couple of things to understand about the Fed before you "buy the bounce when they announce QE3."
 
1. Though nominally independent, the Fed is a political construct. The idea that public opinion and political support have no influence on the Fed is wrong; the Fed's failure to revive the economy while squandering trillions of dollars propping up banks and Wall Street bonuses was not lost on the political class. Though nobody's talking about it, the Fed's abject failure to revive the real economy has greatly diminished its political range of maneuver.
 
Rumor has it that the word has already gone out to the Fed not to intervene with additional trillions to prop up Europe.
 
2. The consensus view is the Fed has either engineered the stock market drop to give it a free hand with QE3, or it will be "forced to do something" to combat the implosion of its pet fix to the broken economy, the "wealth effect" of rising stocks.
 
What these views miss is the Fed is now in a no-win endgame where its best move is to minimize the damage to what's left of its own reputation and credibility. The worst move here would be to double-down on QE3, because if it failed to goose global markets in a sustained fashion, then the Fed's remaining credibility and "magic" would vanish in a puff of smoke.
 
Chairman Ben Bernanke telegraphed this in his recent testimony to Congress, in which he basically stated that the Fed had done all it could and there was little more it could do other than wave a dead chicken and chant a few old incantations. Though he dutifully repeated the standard reassurances, i.e. "There is always more monetary easing we can do," he was careful to lower expectations that such easing would accomplish anything.
 
His testimony was that of someone setting up CYA in a major way. (CYA = cover your behind from recrimination when things head south.)

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