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Tension is mounting towards the FOMC decision about QE2 – the dollar printing program that rocked the markets for a long time. Here are 5 scenarios for the big decision by Bernanke, and the expected impact on the dollar.

Since mid August, the main theme in the markets has been a second round of quantitative easing – a second program by the Federal Reserve to buy bonds. The goal of the program is to pump money into the economy, encourage banks to lend money, and encourage consumers to spend. The high unemployment rate and the lack of significant growth worries the Federal. The worst nightmare is of a long deflationary era – when prices go down, consumers prefer to wait, slowing the economy even more, especially in the American consumer-oriented economy.

Where does the money come from – well, it is created – electronically printed. Creating new money out of the blue devalues the currency, and is already considered by other countries as means of interventions in foreign exchange markets. In addition, printing too much money can cause hyperinflation, which is also dangerous.

There are differences within members of the Federal Reserve about the necessity of a fresh program and its size. They have asked Primary Dealers about the needed size, and tried to see where market expectations stand. This means that more mild scenarios are likely. But, Ben Bernanke can always surprise. And, the extremely high anticipation towards the decision means that any result will rock the markets, during long hours after the announcement.

The highest volatility is expected in EUR/USD and USD/JPY. The Euro enjoyed the expectations for QE2 to make a huge rally. In Japan, one intervention already failed, and the BOJ is set to meet right after the FOMC.

So what are the possible scenarios?

  1. Significant quarterly program: According to a survey made by the WSJ, the Fed will purchase $250 every quarter, for three quarters. This will hurt the dollar initially, but it will later stabilize. Probability: high.
  2. Gradual monthly program: FOMC members Dennis Lockhart and William Dudley spoke about a monthly bond buying program of $100 for a few months, checking out the results very carefully. In this case, the dollar will rise on a relief rally, and will later stabilize. Probability: high.
  3. Initial shock + pledge to continue: Bernanke might announce immediate action to buy $500 billion and a commitment to buy as much as needed. This will significantly weaken the dollar in the short term with high volatility afterwards as well. Probability: medium.
  4. No decision yet: There’s opposition within the Federal Reserve to such a move, coming from Thomas Hoeing and Kevin Warsh, as mapped by Kathy Lien. If they convince the others to wait, the dollar will skyrocket. This is unlikely. Probability: low.
  5. Big Bang: The first program, introduced in March 2009, was in a capacity of $1.75 trillion. Goldman Sachs, that initially spoke about $1 trillion, now talks about 2 to 4 billion. An announcement of such a mountain of money, will send the dollar way down, even if they announce it will be gradual. Probability: low.

Note that any initial move in the markets can be reversed hours later. Fed decisions tend to have a late effect on the markets. Bernanke always rocks the markets.

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