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The Last Thing Left for the Fed to Do


Two key events after the close today will set the tone for the market early this week. Alcoa (AA) will release first-quarter earnings results, the first Dow component to do so, and Federal Reserve Chairman Ben Bernanke will deliver a speech at a Fed conference in Atlanta.

This, after Friday's weaker than expected March jobs report led the S&P 500 and the Nasdaq to cap off their worst weekly losses of the year falling 1% and 2%, respectively. But the bad news comes with a twist. Any signs of economic weakness will presumably keep the Fed's historic stimulus measures in place.

Last week the Fed’s asset holdings swelled to $3.217 trillion, marking 11 consecutive weeks being above $3T. The Fed’s balance sheet is now almost 20% of GDP, nearly matching the record high during the Great Depression, according to Morgan Stanley economist and former Fed director of monetary affairs, Vincent Reinhart.

The Fed is holding key interest rates near-zero and buying $85 billion a month in treasuries and mortgage-backed securities. If they keep expanding at this rate, holdings are estimated to grow to 30% of GDP by the end of 2014.

Some Fed governors are starting to talk publicly about tapering off bond purchases, showing signs they’re growing weary of the impact on the economy.

"They're becoming increasingly irrelevant over the last couple of years, the economy is flushed with liquidity, rates are already at record-setting lows," says Jim Paulsen, chief investment strategist at Wells Capital Management. “I don’t think they’re improving fundamentals by adding liquidity to the system.”

The March jobs report, which showed only 88,000 new payrolls added and a 7.6% unemployment rate, confirms his view.

“Where there is something they could have an impact with, I believe, is if they would start to normalize monetary policy a little bit to try to build confidence,” he says. “I think that’s what they could still do.”

By most accounts, the Fed has done everything in its power to stimulate the economy, while tripling the size of their balance sheet since the financial crisis. Paulsen admits the Fed was successful in helping along the recovery, but his biggest gripe is that our economy is no longer in recession.

“It’s no longer in crisis like it was in 2008 and 2009, and yet monetary policy in this country is more crisis-like and unconventional, and more massive in scope than it was even in 2009,” he states. “So while the economy has moved on from crisis, the Fed clearly hasn’t and it’s leaving the impression that they’re very scared and they’re very nervous about the future of this economy.”

Actions speak louder than words for this investor, and he’s looking for the Fed to reverse course sooner rather than later. In his view, the rally depends on it.

“If they announce that we’re going to stay accommodative, but we’re going to start to back off and normalize policy away from crisis-like policies, back towards normal economic policies, I think it would help raise private sector confidence and investor confidence. And rather than be a negative for the market, which everyone seems to assume, I think it would be a positive.”