Monetary Policy

With eyes toward options for 2012 -- a national election year -- the Fed has opted to keep policy
unchanged, including letting QE2 expire, but reinvest proceeds to keep Fed Bank Credit (FBC) at
the current high level. The Fed is thus setting policy based on its view of mild economic recovery
and a slackening of inflation pressure. They are assuming The enlarged stock of FBC is sufficient
to provide an appropriate liquidity backstop for growth and are figuring that there is bounceback
in the cards as Japan recovers and refills pipelines and that output lost this spring from the large
flooding along the Mississippi will be made up so that there will be adds to demand. They are
also assuming a deceleration of inflation will raise real incomes and consumer confidence, and
figure the expiration of QE2 will help underwrite lower inflation. If they are wrong on economic
demand and it is too slow, QE3 will be an option for next year, which would keep them in the
background of the political battle for the presidency. If the economy surprises on the upside, They
will have every good reason to raise short rates, and can remain in the background as a faster
progressing economy would shift the ground of political debate.

This leaves investors with no easy crutch as with the QE programs, and will put an even larger
premium on the interpretation of unfolding of economic news over the next six odd months. Players
will continue to be circumspect until incoming data enables them to better connect the dots and feel
more assured about strategy. No more hand holding by the Fed? Suck it up and move on and no
whining please.

With the markets for private sector credit thawing slowly and gradually, this is a risky but not
necessarily fatal move by the Fed, especially if inflation pressures are more subdued.