It's God vs. the Federal Reserve

The Federal Reserve is facing many problems and the current economy is desperate for all the the stimulus it can get. Soaring food prices and power plays in the Middle East sending energy prices higher all have the potential to cause consumer-crushing inflation in the United States.

Anthony Mirhaydari
7/25/2012 6:40 PM ET
MSN Money

Since early June, stocks and the economy have settled into a holding pattern. What happens next depends, in large part, on whether the Federal Reserve can continue the recent string of interventions by central banks around the world.

Whether it does depends on acts of God, or possibly, acts of extremism and violence made in the name of religion. Will the worst drought in nearly 60 years abate? Or will it send food prices soaring? Will power plays in the Middle East, fueled by religious hatred and regional ambition, send energy prices higher?

All of these issues hit at the Fed's most vulnerable point: the potential for consumer-crushing inflation.

If something nasty happens soon, it will keep the Fed on hold and leave the economy listless. If prices start rising after the Fed announces another round of stimulus, not only would such increases cancel the benefit of more cheap money, but they could also fuel speculators and make everything much worse, as rising prices did in 2011.

No other lifeline

You see, we need to bolster the economy as much as possible heading into the end of the year. It is then that the "fiscal cliff" of tax hikes and spending cuts worth -- some 5% of the gross domestic product, enough to start another recession -- looms. Wall Street analysts are busily marking down their growth estimates. From near 2.5% in May, the consensus now sees 2013 growth clocking in at a 1.5% annual rate.

That's dangerously close to the economy's stall speed. And it isn't fast enough to cut the unemployment rate.

The evidence of a global slowdown is plain. European manufacturing activity has plunged to a three-year low. Job growth has been halting here at home. And in Asia, the rise of the middle class, with its once-insatiable appetite for the West's finer things, has stalled: According to Morgan Stanley analysts touring Hong Kong, there has been a marked slowdown in consumer spending, particularly for high-end global brands.

citigroup

o put it in a nice, round number, 70% of U.S. economic data points since the beginning of June have missed expectations to the downside. That's pushed down the Citigroup Economic Surprise Index to lows last seen during the growth scares of 2010 and 2011, ahead of big rebounds in the economy and the market, thanks to Fed policy intervention and progress in Europe.

The uncertainty and fear driving all this -- be it the potential for a eurozone breakup or the U.S. fiscal cliff -- is hitting the corporate sector, and therefore stocks, as the real economy slows. The chart below shows that the global ISM manufacturing activity index and earnings revisions have fallen to levels not seen since late 2007, as recession loomed.

global

In this context, and as summertime trading volumes dwindle, equities have been gapping and bouncing like grasshoppers but not making steady movements up or down. Economic data have been poor but not shockingly terrible, and there are signs of hope, including a slight bump in incomes, lower fuel prices and stabilization in the housing market -- points of light I discussed in a recent column titled "A new US recession? Not yet."

Investors just can't decide if things are going to get better or worse. For now, they are stuck in the middle, with a slightly bearish bias. According to Investors Intelligence, newsletter writers are refusing to get bullish, or bearish, on a scale that's been seen only twice since 1970. The American Association of Individual Investors notes that bullish sentiment has been below average for 15 straight weeks. That hasn't happened since 1993.

The will to act

Fed policymakers are clearly preparing to do more. The Fed's next policy announcement is next week, on Aug. 1. Fed governor Sarah Raskin said she expects to talk about a third round of outright bond buying, or "QE3," at that meeting. Fed mouthpiece Jon Hilsenrath of The Wall Street Journal wrote in an article published Tuesday that officials "impatient with the economy's sluggish growth and high unemployment, are moving closer to taking new steps to spur activity and hiring."

Options under discussion appear to include a QE3 focused on mortgage securities, extending the Fed's near-0% interest rate commitment beyond 2014 or pushing the interest rate it pays banks that park funds at the Fed's vault down to 0% (from 0.25% now on some $1.5 trillion in excess reserves) -- mimicking a recent move by the European Central Bank.

Last month, the central bank extended its $400 billion "Operation Twist" initiative - whereby it sells its short-term Treasury bonds and buys long-term Treasury bonds as it tries to lower long-term interest rates -- by $267 billion, keeping the operation running through the end of the year.

Minutes from the Fed's June meeting show that a "few members express(ed) the view that further policy stimulus likely would be necessary," while "several others" thought additional action could be warranted if the economy continued to cool.

Well, it has cooled. Inflation has dropped below the Fed's target, with consumer price inflation falling from nearly 4% last September to just 1.7% now.

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