LONDON (Reuters) – FOMC meetings are usually a strange combination of formality and easy-going familiarity but levity may be in short supply this week. The Fed’s institutional credibility is on the line, and the normal decorum that characterises relations among committee members has become increasingly strained over the summer.

Divisions between proponents and opponents of a second round of quantitative easing (QE2) have been on display as never before. It is not clear what members will say to one another to fill two days since all the arguments have already been rehearsed in detail and in public over the last six weeks.

In a thinly veiled swipe at his colleagues, Kansas City Fed President Thomas Hoenig has stumped around his patch on the Great Plains denouncing QE as a “dangerous gamble” and “a bargain with the devil”.

Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser have made no secret of their scepticism or outright opposition to launching QE2 at this point. Minneapolis Fed President Narayana Kocherlakota has questioned whether it will work. Richmond Fed President Jeffrey Lacker has seemed to doubt whether it is necessary.

In contrast, the New York Fed (always the closest to the major money centre banks) and the St Louis Fed (the spiritual home of monetarism in the Federal Reserve System) have openly campaigned for the benefits of a second round of asset purchases.

The final vote to adopt QE2 looks set to be 10-1 (with Hoenig dissenting). But the tally will mask much wider misgivings among the non-voting regional presidents and perhaps among some members of the Board of Governors itself, who will nonetheless fall in line with the chairman to support his authority.

FIVE DIMENSIONS

LONDON (Reuters) – As the Federal Reserve considers a new round of quantitative easing (QE2) it is worth asking what purchases on the initially forecast scale would do to the market for the U.S. Treasury securities and the distribution of investor portfolios.

St Louis Fed Research Director Christopher Waller recently indicated the programme might begin with a target of buying $500 billion with further increments of $250 billion.

The St Louis Fed has been at the forefront of the campaign for more QE to avert the peril of deflation, so Waller’s views may not reflect the overall balance of opinion within the central bank. Other officials are more sceptical.

A Wall Street Journal report suggests the Fed is preparing to announce an initial “more measured” programme of only “a few hundred billion”.

Until now, many observers were anticipating the central bank will eventually purchase between $500 billion and $1 trillion of mostly or exclusively U.S. Treasury securities.

Purchases on this scale would effectively drive private investors out of the medium-term government bond market and forcibly alter the composition of their portfolios on an unprecedented scale.

Fear of the consequences is one reason the Fed may pull back and announce a smaller programme.

LONDON (Reuters) – No question is more important to commodity investors at the moment than whether quantitative easing (QE) would give a further boost to prices if the Federal Reserve announces a second round of asset purchases at the conclusion of its next meeting on Nov. 3.

PROGRAMME DESIGN

Expectations for a new round of QE, fanned by the central bank itself, have now gone much too far for the Fed to hesitate. Some form of asset purchase programme is a foregone conclusion. But officials are now grappling over three interconnected aspects of a new programme:

(1) Total value of assets to be purchased. Officials are split over whether to announce large-scale bond buys, which would maximise the psychological impact on market prices and inflation expectations but risk accusations the Fed is monetising the entire federal budget deficit, or a smaller programme, which would be less sensitive politically but risk disappointing elevated market expectations.

There is acute sensitivity around announcing a high overall total. Several prominent investment banks, led by Goldman Sachs, have called for purchases of around $1 trillion, and the Fed is anxious not to be seen allowing Wall Street to direct policy.

The federal budget deficit is also running at $1.3 trillion per year ($100 billion per month). Announcing a purchase programme on a similar magnitude would leave the Fed open to the accusation that it is monetising the entire borrowing requirement and creating a false market in U.S. Treasury securities.

(2) Total amount or purchase rate. Officials seem uncertain whether to announce a single programme total (perhaps $500 million or $1 trillion) or state that the central bank will buy a smaller set quantity over the intermeeting period, next month or next quarter — leaving subsequent meetings to decide whether to continue purchasing securities at the same rate or increase, reduce or end the programme.

LONDON (Reuters) – “Market participants should not direct policy,” Kansas City Fed President Thomas Hoenig warned listeners at a town hall meeting in Lincoln, Nebraska, back in August. Unfortunately that is precisely what is now happening.

Hoenig noted that Wall Street’s clamour for cheap money was not disinterested: “Of course the market wants zero rates to continue indefinitely … they are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.”

Now the same pressure groups want the Fed to launch a second round of asset purchases so they can sell U.S. Treasury bonds to the central bank (in effect back to the federal government) at inflated prices.

A new round of securities purchases provides investors with an exit strategy from what might otherwise be a dangerous bubble in the bond market. Every bubble needs a “greater fool” prepared to pay a higher price for the asset to keep the bubble inflating. In this case, the guaranteed sucker is the Fed itself.

Meanwhile quantitative easing (QE) has pushed up the value of all the risk assets institutions and investors hold, giving the market a highly desirable insurance policy.

Set aside the question of whether the Fed should socialise investors’ risks and losses in this way. Set aside also the issue of moral hazard — whether by bailing out investors the Fed will encourage more excessive risk-taking behaviour in future. Most officials admit recent actions have increased moral hazard but believe it is a problem to be solved in the long term by appropriate supervision.

The immediate policy question is whether the prospective QE programme is contributing to stability in the financial markets and an environment likely to encourage more long-term investment by businesses and job creation. In other words, is QE succeeding in its own terms, meeting the objectives set by the central banks themselves?

LONDON (Reuters) – President John F Kennedy popularised the aphorism that “a rising tide lifts all boats” but he might have noted that it does not lift them all equally.

The same is true of quantitative easing. Prospects for another round of securities purchases have lifted prices for a broad spectrum of assets. Not just medium-term Treasury notes the Fed is thought likely to buy but corporate bonds (that are near substitutes) and riskier assets (such as commodities and equities).

The Fed terms the mechanism by which bond purchases force investors to change the composition of their portfolio and hold more high-risk assets, spurring private sector borrowing and investment, the “portfolio balance effect.”

The problem is that injecting liquidity does not affect all asset prices evenly.

In the face of high levels of uncertainty about the outlook (inflation, deflation, expansion or a double dip?) and the Fed’s policy response (how much QE and for how long?) there is good reason to believe investors will prefer highly liquid financial assets (bonds, equities, currencies and commodity derivatives) to less liquid ones (buildings, equipment and software). Liquid assets provide a safer exit strategy if expectations turn out to be incorrect.

Among the constellation of liquid assets, uncertainty and fear about mounting monetary and price instability seem likely to steer investors towards those companies, countries and commodities thought to have the most pricing power, with the fewest competitors and suffering the least over-capacity. Only once opportunities in these companies, countries and commodities are saturated are investors likely to show strong interest in value sectors with more surplus capacity.

COMMODITY DIFFERENTIATION

LONDON (Reuters) – In 1987, UK Prime Minister Margaret Thatcher whipped up a firestorm of criticism from her opponents on the left when she told a magazine reporter that “there is no such thing as society”, only individual men and women, and families.

The interpretation of those comments remains fiercely controversial. From the context it is not certain the prime minister was clear what she was trying to say.

But according to one interpretation the prime minister was encouraging her listeners to look beyond the impersonal aggregate of “society” to the individuals behind it.

The distinction between aggregates and individual components is something the Federal Reserve should bear in mind as officials mull whether to launch a new round of asset purchases to keep inflation from falling further and stimulate the recovery.

Because in some sense there is no such thing as inflation, only a collection of price rises for individual items, some rising faster and some slower.

It is clear price increases do have a structural component. Policymakers and economists distinguish between a general rise in the level of prices (“inflation”) and relative price increases for individual items (Adam Smith’s “invisible hand” guiding the reallocation of scarce resources).

But in an economy characterised by uneven spare capacity, with bottlenecks in some areas and unused capacity in others, excess demand and inflationary pressures may not show up evenly. Even as all prices rise (inflation), price rises are likely to be largest in those parts of the system with the worst bottlenecks, while increases in areas suffering significant under-employment of resources lag behind.