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Eulogy to the Fed

Stocks in this article: GLD SPY USO UUP DBA UDN

In the Fed's own words from the announcement, "information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months." Inflation expectation had been going up above 2%; at close of Thursday it surged to 2.27%. Why now? Why not wait for some clear sign of economic weakness before acting? Why switching the focus to unemployment at this point in time?

It is theoretically possible that Bernanke has at his disposal some amazing forecasting model that sees a pending Lehman-class disaster, say Greece or Germany exiting the euro or Spain defaulting, or severe economic slowdown in the near future. Even then it doesn't make any sense to take pre-emptive action for two simple reasons: 1) you just don't know until it actually happens, and 2) pre-emptive disaster prevention before anyone sees the danger has the problem of having nothing to show for your success, by definition. It's economically risky and politically stupid.

Another fact is that the Fed's balance sheet automatically shrinks if they do nothing, as the bonds they hold accrue interest, mature or get pre-paid. But the rate of this shrinkage is only about $10 billion a month. By adding $85 billion a month, as announced for QE3, the Fed's balance sheet will increase $75 billion a month net, indefinitely. Even the most wild-eyed, far-out QE junkie dared not to expect this.

Some may say "indefinitely" also means he can stop any time. True. But the burden of proof for deviating from $40 billion is now very high, especially on the low side, given Bernanke's explicit promise that he will be late rather than early in stopping the stimulus. It's also odd that they didn't even bother to leave some flexibility in schedule, something along the line of "about $40 billion, subject to the committee's discretion taking into consideration any new economic data." No -- $40 billion, period. This is just absurd.

Political Motive

The only rational explanation left is election politics. This is the only factor with a hard expiration date. And it neatly explains the sudden shift of focus to unemployment rate. Remember how everyone was saying that no president gets re-elected when unemployment runs above 8%?

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