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Fed May Hold Key to Unlocking Range-Bound Market

The Fed typically provides added economic stimulus at this point in the economic cycle.

It may all come down to the Federal Reserve this week. The message from the Fed at 2:15 pm ET on Tuesday, Sept. 21 may hold the key to whether the stock market breaks out of the range that has bound the S&P 500 since May, or remains within it (see chart below).

Historically, the Fed has typically provided added economic stimulus at this point in the economic cycle. The response by the Fed to uncertainty over the economic environment has been anything but uncertain: they have always provided the economy with one last booster shot of stimulus.

During the past four decades, the Fed has cut rates one last time well after the recession had ended when a soft spot emerged. For example, the Fed cut the Federal Funds target rate in Sept. 1992 and June 2003 -- taking place about a year and a half past the end of the recessions of 1990-1991 and 2001.

With rates effectively at zero, the Fed has told us it has three policy tools to boost growth if the outlook worsens:

1. Purchases of bonds to add more money to the system is called quantitative easing (QE) because it adds to the quantity of money in the system rather than lowering the price of money, or interest rates.

2. Modifying communication to suggest "extended period" means the Fed is on hold for an even longer period of time than currently believed.

3. Reducing the interest rate paid on excess reserves held by banks at the Federal Reserve in order to encourage them to lend the money rather than hold it at the Fed.

Fed Chairman Ben Bernanke, in a recent speech, dismissed the last two options as less effective. Indeed, with the market not pricing in rate hikes until late next year anyway, the second option is unlikely to be effective. With the Federal Funds rate already near zero, the effect of the third option, in the Fed Chairman's own words, "would likely be relatively small" and poses the risk to "disrupt some key financial markets."

The Fed has made its preference for the first option, QE, clear. The Fed took a small step in this direction at their Aug. 10 meeting when they committed to purchasing Treasuries as the housing debt they hold matures. The goal is to maintain its total securities holdings at about $2 trillion and avoid passively draining money from the financial system.

However, we believe the Fed is not likely to take the next full step to QE without a downgrade to its recently stated growth outlook, which includes above-average gross domestic product (GDP) growth in 2011 and a 1% decline in the unemployment rate over the next year. The Fed remains significantly more optimistic than the consensus of professional economists.

If the uncertainty lingers, and the Fed is compelled to downgrade their outlook, the Fed could pursue the path of further easing consistent with prior early cycle periods of uncertainty. We put about a 25% chance on QE in September, with a greater chance of action at the November meeting that is scheduled the day after the mid-term elections.

Why would they wait? Further QE would have to be substantial to do much to spur employment growth given the enormous liquidity already on the balance sheets of banks and businesses. In addition, if inflation begins to take root, a worse economic outcome than the sluggish environment could result from a sharp rise in long-term interest rates sparked by worries that the Fed will be too slow to react to pricing pressures as it remains focused on near-term growth. There are some early signs of resurging inflation beginning to appear:

Agricultural commodities are soaring and in some cases, such as meat, sugar, and coffee, producers are passing higher costs onto consumers.

The dollar has been on a downward slide against the yen and euro, making imports more expensive and easing foreign price competition on domestic producers.

Gold and silver are hitting new highs.

The combination of the Fed's more optimistic outlook for growth over the next year, the limited benefit of additional action on growth and employment, and the threat of inflation pressures is likely to keep the Fed on hold in September.

However, if the Fed does act and announces QE at their meeting on Tuesday, the stock market may break out of the current range to the upside. Market participants would be likely to see the action from the Fed as a backstop against a double-dip recession rather than having the potential to cause problematic inflation.

If the Fed does not take action, what will the market do? The Fed will likely signal its sensitivity to heightened risk by updating the message from the August meeting that it "is prepared to take further actions as needed." This will send the signal that the Fed has a greater bias toward easing monetary policy, but leave market participants guessing when the outlook may deteriorate enough to invoke action from the optimistic Fed.

While the Fed may feel a little better about the economy since they last met in August, their enthusiasm must be limited. The past few weeks of economic data was better than expected, however, most conditions are pointing to an environment of slow growth. The lack of action could reinforce the range the market has been trading in for the past four months leaving stocks to consolidate recent gains or pullback with the range of 1125 to 1025.