"If the economy grows more quickly than I currently anticipate, the purchase program will need to be reconsidered and perhaps curtailed before the full $600 billion in purchases is completed. On the other hand, if serious risks of deflation or deflationary expectations emerge, then we would need to consider whether expanded asset purchases should be used to address these risks. However, we would then need to clearly communicate that we were taking this step to combat deflation and deflationary expectations, and not as an action to speed up the recovery."

Look for this type of communication to continue if we do not see some good numbers coming into the new year.  I believe the Fed knows there is a lot of backlash from QE2 and wants to start seeding for another round if necessary but without the tongue lashing. 

I was encouraged that he addressed the downside to this program:

"…if banks began to put the reserves to use in the same manner as they did before the crisis, money in circulation would increase sharply. We do not know when that will happen or how long it will take for the banking system to make the adjustment."

You didn't think the volatility was in the rear view mirror did you?  It sets up to be memorable when the Fed unwinds their balance sheet.  Not only in the markets but from other angles as well:

"Because the Fed’s monetary policy must be forward looking, the hue and cry from many quarters may be quite loud when it is time to act"

Brad Lehman

I like to look at the perspective of the governing forces (whether it is the Fed or officials in Washington).  The question I ask myself is what are the incentives?  As an example, look at the stock market.  What would happen if it plunged and stayed down to extremely low levels?  The quick answer is we would be in a lot of trouble.  Pensions, personal portfolios, consumer confidence, marked assets on balance sheets, counter party risks, etc.  From a Federal Government perspective or a Central Banker’s perspective, it is of utmost importance that this market does not plunge.  It is a lot cheaper to fund markets than to bailout every counterparty, pension, and even decimated consumers.   To quote Greenspan:

“It's important to remember that equity values, stock prices, are not just paper profits.  They actually have a profoundly important impact on economic activity.  And if stock prices start continuing down, I would get very concerned.”

The wealth effect has not been lost on the current Fed chairman so look for continued “support” of our equity markets.  How about bonds?   A different market but the incentives are there.  Can we really afford to have high interest rates and/or illiquidity in all our markets?  Alas, you have intervention in various markets to bring interest rates down and provide liquidity.   Go back a couple years and try finding a bid on the various bond markets (mortgage, municipal, and corporate bonds).  For a time there, we witnessed a world without support from the Fed and Washington.  The debate will continue on whether the price tag will be worth it or whether we should have just taken the tough medicine and let many businesses go down. 

For todays trading, the lower interest rates and liquidity are helping balance sheets in both private corporations and government entities.  It has been an impressive year in terms of the rallies in all markets.  Courtesy of the incentives by your governing bodies.  What does 2011 hold in store?  There is a glimpse of what can occur without the support when you look at the municipal bond market.  With questions on the Bush tax cut extensions, Build American Bonds, and budgets, you have seen a sharp sell off from the highs.  The year ahead will see continued pressure from the pension mess that exists along with ad valorem tax reductions.  Look for more federal support in the municipal front in the years to come.  Its form will develop this year and will be updated here.

Brad Lehman