QE2: Will the Fed Surprise the Markets?

(Updated with latest ADP private-sector employment numbers)

NEW YORK ( TheStreet) -- Will the Federal Reserve's move to boost the flagging U.S. economy be too little to make a difference or will it be too much, too soon? That is the big question for investors anxiously awaiting the Federal Open Market Committee statement on Wednesday afternoon.

The S&P 500 has risen 14% since the central bank first hinted that it will resume the purchase of long-term assets to boost the economy -- dubbed QE2 -- in August. While the prospect of quantitative easing has driven down the dollar and helped push up stocks, investors remain uncertain of what the actual outcome of the Fed's move will be on the economy and job growth, as the central bank heads into unchartered territory.

Skeptics have said that further quantitative easing will do little to help an economy that is stuck in a "liquidity trap" and would only succeed in creating dangerous asset inflation. Supporters argue that the Fed must use every tool it has at its disposal to prevent the economy from slipping back into a recession and to keep the threat of deflation at bay.

Fed chairman Ben Bernanke and his colleagues have, in various speeches over the last two months, tried to steer market expectations in a spirit of transparency. But Fed officials themselves have voiced disagreement on what the size and nature of the monetary stimulus should be -- and some have questioned whether it is warranted at all. The dissent within the central bank has led to divergent market expectations on what the central bank's ultimate announcement will look like.

Estimates have ranged from $50 billion to $100 billion in monthly purchases over several months from those who expect an open-ended approach by the Fed to an injection of anywhere between $500 billion to $1 trillion through the end of 2011 by analysts who predict the central bank will make a more significant push. But the broad consensus appears to be settling at $500 billion.

Brian Bethune of Global Insight expects the Fed to announce a minimum limit of $500 billion, a floor that was set by New York Fed President William Dudley in early October. "The Fed may give a range of $500 billion to $800 billion and make incremental purchases of $100 billion a month, which will then be calibrated to the performance of the economy," said Bethune. "This will give it some wiggle room to do a significant amount but not do too much."

Bethune expects that a $500 billion bond purchase program will help lower long-term yields by a quarter basis point. If the Fed acts on the higher end of the range, long-term yields could drop by a half basis point.

Marc Pado of Cantor Fitzgerald believes that the Fed will probably meet market expectations on size as it has stayed silent amid reports of a $500 billion ease. "Usually if the Fed doesn't like what Wall Street is talking about, they come out and say something to let people know that they're looking in the wrong direction," Pado told TheStreet. The real question, he says, will be "Over what period of time?"

"Part of the statement might make a difference in terms of how quickly or through what instruments the stimulus will be implemented, but overall, I think the amount and the direction is quite clear," he said.

Burt White, CIO of LPL Financial, believes that the Fed has lowered expectations in the last couple of weeks but that it might still surprise the market. "I think the market is pricing in somewhere between $75-$100 billion (of monthly purchases), but I don't think they are pricing in more than that and I think we might get it. I think we might get a front-end loaded amount ... a little bit more now and maybe less month-to-month going forward to get a bit of a jump start here. I think Bernanke knows that a couple of the members that are going to be coming on as voting members of the FOMC in 2011 are pretty hawkish and he knows he has to get some of this through now because he might not be so successful in 2011 in getting some of these aggressive easing measures done," he said.

Bethune of Global Insight does not think a front-ending of the purchases is likely, however. "There is not enough supply to be front-ended. The Fed does not want to disrupt the treasury auction market too much," he said.

Bethune expects the policy statement to contain language that suggests the program will be adjusted based on how the economy progresses. Bernanke already said in his Oct. 16 speech that the Fed will have to proceed with caution given central banks' relative inexperience with this move.

"One disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public," Bernanke noted. "These factors have dictated that the Federal Open Market Committee proceed with some caution in deciding whether to engage in further purchases of longer-term securities."

The Fed is embarking on another program of quantitative easing in hopes to boost employment and inflation as it notes that unemployment rates are unsustainably high and inflation too low.

Last Friday, the government said the economy expanded 2% in the third quarter, in line with market expectations but still not high enough to generate jobs. The economy shed 95,000 jobs in September, with the private sector adding only 64,000 workers.

On Friday, the Labor Department is expected to report that nonfarm payrolls grew by 60,000, according to consensus estimates from Briefing.com. The ADP National Employment Report released on Wednesday morning said the private sector added 43,000 jobs in October, which could lead to an upward revision in estimates, but growth in jobs is still not enough to reduce the unemployment rate.

Brown of Raymond James says the economy still needs to add 100,000 to 120,000 jobs just to keep pace with population growth and about 200,000 to 300,000 jobs a month to signal a strong recovery.

The Fed hopes that if it buys more Treasuries, it could help temporarily depress long-term interest rates and drive investors towards riskier assets, stimulating investment and spending and thereby the economy.

But mortgage rates and interest rates are already low and have failed to stimulate housing and business spending so far, as households and businesses continue to slash their debt exposure. That is because the economy is in what Federal Reserve official Charles Evans described a liquidity trap.

Last week, reputed Pimco investor Bill Gross called the Fed's decision to print money a "Ponzi scheme" and said further easing would signal the end of a 30-year bond rally as inflation was inevitable.

Users polled by TheStreet said the Fed's QE2 won't boost the economy and that the central bank risks runaway inflation.

Bethune says the Fed may prove those doubters wrong. "Skeptics are getting a lot of play with their 'world is coming to an end' theories," said Bethune. "This could be a very effective tool. A lower dollar will have knock on effects," pointing to the recent bump in export figures as an indicator of things to come. "The problem with the lower U.S. dollar is that it exports problems elsewhere.... But a lower U.S. dollar is necessary to get the economy over this hump," he said.

--Written by Shanthi Venkataraman in New York

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