ANALYST: If Bernanke Is Smart, His Next Step Will Be To Increase QE

Yesterday, Federal Reserve Chairman Ben Bernanke put a cap on Treasury yields when he suggested that the unemployment rate probably understated weakness in the labor market – implying that interest rates would remain pinned near zero longer than expected – and indicated that the rise in bond yields of late has represented a tightening of financial conditions, which could require addressing if it continued.

Bernanke also warned that low inflation in the U.S. warranted more monetary stimulus, and that falling inflation could be bad for the economy.

The Fed chairman's comments are giving stocks and bonds a lift, sending yields back down again, and the message finally seems to be getting through that tapering the pace of monthly bond purchases under quantitative easing doesn't mean tightening of monetary conditions.

The problem is that just a few weeks ago, at the FOMC press conference on June 19, when asked about the sell-off in the Treasury market and the attendant rise in yields, Bernanke said that it was a good sign to the extent that it reflected confidence in a strengthening economy.

He also laid out a timeline for when quantitative easing could end altogether (by mid-2014, when the Fed projects the unemployment rate will hit 7%). Some saw this as limiting the Fed's options somewhat, because if the economy took a turn for the worse again and the Fed had to increase bond purchases, it could damage the central bank's credibility with the market.

The tapering timeline introduced by Bernanke in June suggests a total of $4 trillion of bond purchases under quantitative easing by the time the program comes to an end. Andrew Wilkinson, Chief Economic Strategist at Miller Tabak, suggests that Bernanke could "out think" the market by actually stepping up the pace of monthly bond purchases to get to that $4 trillion faster.

In a note to clients, he writes:

If Bernanke is a really a good student he might out think the market in order to counter the turbulent headwinds created by rising winds. Jim Bullard was pretty vocal according to the minutes of the June meeting by urging the committee to signal commitment to lifting inflation back to its target of 2%. But by signaling at the time that the Fed would start to reduce bond purchases, Bullard felt that this would limit the bank’s flexibility in the amount it buys.

Bernanke could reach $4.0 trillion faster by stepping –up the pace of purchases from its current $85 billion, justifying his decision on grounds of low inflation and the counter-productive rise in yields. At the same time the Fed could maintain that it is sticking to the same script claiming that the economy is doing better than prior to the announcement of QE3 and that the labor market appears to be making sustainable gains.

"Buying more bonds for a shorter period of time would fit perfectly well into the framework the Federal Reserve has set forth," says Wilkinson. "At the same time it could counter the recent rise in yields and send a stronger message to bond market participants that they are acting prematurely, especially when the medium-term outlook for inflation is sending downside risks."