Fed Possibilities

Chairman Bernanke will announce his policy decision Wednesday at 12:30 EST, and considering the recent escalation in the European debt crisis and a worsening fundamental economic picture in the US, the possibility of further policy action has risen.

Here is a quick breakdown of some of the options on the table:

1. The Fed extends Operation Twist. In this case, the Fed will continue to sell the remaining short-dated treasury bonds on its books (approxiamately USD200bn) and buy longer-dated ones, thereby lowering long-term interest rates. Some market participants believe this action by itself will be ineffective considering the headwinds that remain.

2. The Fed extends its guidance on how long it will be keeping interest rates at or below 0.25%. At present, the Fed has indicated that it will maintain its key lending rate at 0.25% until late 2014, however it could signal an extension of that guidance to 2015 or beyond.

3. The Fed decides to expand its balance sheet. The Fed could decide to increase the assets it holds by buying bonds in the secondary markets. They would likely target mortgage-backed securities in order to ease loans within the housing and consumer markets. This is the most favoured outcome for risk assets such as stocks, commodities, and growth currencies like CAD and AUD. The argument as to why the Fed would continue expanding its bloated balance sheet via mortgage bond purchases is that they have consistently cited the housing market as the key to a stronger economy. And with job growth and housing starts both faltering lately, we just might see such a programme sooner rather than later.

Stay tuned.