FOMC Focus: Give a little, keep it vague and hold back ammunition

When Federal Reserve Chairman Ben Bernanke testifies today at 4pm CET before Congress on the US Economic Outlook he will speak against a backdrop of weak US employment growth, a non-threatening inflationary environment, and a very threatening global environment, with the potential for a post-Lehmans-like cataclysm in the event of a Euro disintegration or, at the very least, continuing uncetainty over the future of the Euro, coupled with the imposition of excessive austerity, leading to persistent downward pressure on American 'animal spirits'.

Add to this the impending 'fiscal cliff' in 2013, with its potential to impose a significant tightening, and one can make a persuasive case for further Fed easing. This certainly seems to be a view shared by his Vice-Chairman, Janet Yellen. In her speech only yesterday she was at pains to point out the dangers to economic recovery. Here are some of the headlines:

**Fed's Yellen sees significant downside risks to economic outlook, may well be appropriate to insure against adverse shocks
**Yellen: Risk management considerations strengthen case for additional accommodation beyond what is called for by policy rules
**Yellen: Fed has scope to provide further accommodation either through forward guidance or additional balance sheet actions
**Yellen: If recovery proceeding too slowly, fed could undertake portfolio actions such as asset purchases or further maturity extension program

It is a classic Fed tactic for senior Federal Open Market Committee members to drop hints in advance of policy changes, but Bernanke's words today will carry the greatest weight.

Give a little, but keep it vague?
The dovish big-hitting troika who rules the Fed, Chairman Bernanke, VC Yellen and NY Fed President Dudley, are all acutely aware that even doing nothing implies an 'accidental' tightening of policy over time, as the effects of the shock of Quantitative Easing (QE) announcements wear off and the duration of the Fed's assets obviously diminishes as the months slip by. Failure to act soon will also mean that the US Presidential election becomes perilously close, meaning that any Fed easing will increasingly expose them to the accusation that they are 'helping' President Obama.

The only strong counter argument would seem to be the need to keep some powder dry, in case the increasingly worrisome Eurozone crisis really gets out of hand. On balance therefore, whilst I would expect Chairman Bernanke to drop Delphic hints about imminent further accommodation, I don't think he will say anything specific enough to allow the markets to immediately expect further full-blown, unsterilised QE. This may represent something of a disappointment for risk markets.

Which tools might come out of the box at the June 19/20 meeting?
There are a myriad of different easing options, and combinations of same, at the Fed's disposal. They can increase the size of the balance sheet in various different ways - mortgages or Treasuries - and can either choose to increase the net amount of excess bank reserves, or they can 'sterilize', either by indulging in further 'Twist' operations, in which they buy long-term securities, but finance the purchases by selling shorter dates, or they they could conduct reverse-repo operations to drain the 'printed money'.

Also, reverting to interest rate policy, they could extend their guidance that rates will stay where they are even longer than the current end-2014. Finally, there are the more whacky possibilities - a higher inflation target or a nominal GDP target.
I would look for hints today that they will buy a cocktail of mortgage debt and longer-term (7-year+) Treasuries with a suitably enigmatic reference to the possibility that purchases could be subequently sterilised; the startegy being to hold back some ammo, as Greek elections and further developments in Spain's banking crisis could change the landscape massively before the next FOMC meeting.

If the Eurozone really does disintegrate, then a higher inflation target and/or a nominal GDP target are the delights that await us, as then the Fed, and all of us, really will be running scared.