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The Federal Open Market Committee (FOMC) duly met for two days last week, completing the cycle of three set piece events in the US over the last month designed to set the political and economic agenda for the next year. Despite many fine words and some interesting plans the market reaction was clear cut. Risk – off is back in fashion with US Treasuries up and equities down in the following days. The question for those looking for a reason to be optimistic was – is that all? Ben Bernanke’s Jackson Hole speech is part of the annual calendar, but could have been the catalyst for a recovery because of what happened in 2010. In the event he outlined the Fed’s options, following the action plan he set out in 2002, and then passed the buck to the President.

US Federal Reserve

President Obama’s speech to a joint session of Congress was an unusual event. He asked for it and, after being kept waiting for an extra day, was invited on to the platform. He was expected to deliver something special. His speech contained several major initiatives which, if implemented in full, could add between 1.5% and 2% to US economic growth next year. Unfortunately for the President it is unlikely that the Republican controlled House of Representatives will pay much attention. Instead the lasting impression is that the speech had more to do with electioneering than putting America back to work. So markets were left with two weeks to anticipate the FOMC meeting on 20th and 21st September. Again this seemed to promise something special because the usual one day gathering had been extended to two. The announcement when it came offered slightly more than had been anticipated with Operation Twist at the high end of expectations and with mortgage backed bonds included for the first time. The plan is to sell $400 billion of shorter dated bonds maturing over the next three years and reinvest in longer dated securities due to be redeemed between 6 and 30 years from now. The Fed hopes that this will lower long term interest rates and so stimulate loan demand and economic growth. No new money is to be created, which will please the Republicans, and the consensus is that this rather technical operation will have relatively little effect on economic growth or confidence. In fact any potential benefit was cancelled out by the accompanying statement which downgraded the economic outlook from ‘downside risks’ to ‘significant downside risk’. Unlike voters who will have to wait another twelve months to exercise their democratic right, investors who get to vote all day every day decided that 2012 was likely to be a tough year for growth and voted accordingly. The issue now is why so much effort has delivered so little. There are various possibilities. It could be that the Fed has run out of options and in the absence of political leadership nothing more can be done until the voters have their say. That means waiting until 2013 when the President (existing or new) will have a mandate for action. Alternatively, and I think more likely, the Fed spent the extra day on scenario planning in anticipation of European trouble. Europe might be outside the Fed’s mandate but there would be collateral damage amongst US banks if there are unplanned defaults by European governments (Bernanke 2002 action plan; make sure that the banking system and capital markets are well capitalised and liquid) and recession in Europe could hardly be considered good news for the US economy as a whole. If European governments fail to solve their debt problems then the US will need a plan. Just as Pearl Harbor allowed Roosevelt to redefine American international policy, problems in Europe could provide cover for the Fed and US Treasury to implement more radical action to stimulate growth sooner rather than later.