Tuesday's release of the December FOMC minutes received a slightly negative reaction from the equity market. This underscores a point we have been emphasizing for some time: that the effectiveness of the Fed's "portfolio balance" channel is diminishing.

While it could be argued that the message from the explicit change to the Fed's communication strategy - including forecasts for the policy rate in the quarterly Summary of Economic Projections (SEP) - was more technical than tactical, our read is that these minutes show a Fed slightly more concerned about the economic outlook than what was implied by the statement released December 13, 2011, and while additional easing is not in our economics team's baseline forecast, a deterioration in the outlook would probably prompt a monetary response. In our view, additional easing is likely to come in two forms: from enhanced communications strategy and later, if necessary, through another round of large-scale asset purchases.

Given the Fed's view of NAIRU and its projections for the unemployment rate (ie, labor market slack), adding forecasts for the path of the fed funds rate likely facilitates extending its current "pledge" to keep the policy rate effectively at zero beyond mid-2013. In our view, the Fed leadership will likely alter the "mid-2013" guidance in the FOMC statement and instead use language that is consistent with the consensus date of policy tightening implied by the projections. In all likelihood, this will result in extending the expected horizon of the zero rate policy beyond mid-2013. However, there is the possibility for poor execution of communication, given the range of participant views (eg, hawkish members biasing the mean toward tighter policy; please see Minutes of the December FOMC meeting: Publishing participants' projections of the federal funds rate, January 3, 2012). However, in our view, the Fed leadership will craft language that ultimately extends the zero rate pledge. In addition, we suspect Chairman Bernanke would like the formal adoption of an inflation target to be part of his legacy, so we expect to see further progress on this issue in the months ahead.

A second reason for believing the Fed is edging toward additional stimulus comes from the discussion of participants' views on the household sector. In essence, they are concerned with the sustainability of the stronger-than-expected consumption in H2 11. The potential for weak real disposable income growth and ongoing cautious corporate investment in capital and labor, driven by uncertainty about the economic and political environment, likely contributed to this view. The staff also marked down its medium-term forecast for real GDP growth, somewhat surprisingly, given the positive trends in the data at the time of the meeting. In our view, any signs of softening of consumer spending could be met with another round of large-scale asset purchases, perhaps as early as late in Q1 12, but more likely in Q2 12.

While some might be inclined to view additional policy easing as a positive equity market event, we do not. From a long-term perspective, we have written extensively about how the financial repression in the late 1940s/early 1950s contributed to single-digit PE multiples and an elevated equity risk premium (ERP). Today, in our view, a period of secular multiple expansion is unlikely before the Fed begins the exit strategy process. From a tactical perspective, note that the period of a shrinking ERP in response to the three zero interest bound stimulus programs (QE1, QE2 and Operation Twist) has been successively shorter while the broad trend in the ERP has been higher. In the case of Operation Twist, which took more duration out of the market (via purchases of long-term Treasuries) than QE2, the ERP contracted for only one month. It expanded prior to the beginning of each of these easing steps, following the announcements, often due to declining stock prices as the equity market initially focused on the Fed's downgrade of the economic forecast ahead of the potentially positive effects of easing. In other words, equity market participants worried that the Fed knew something about the economy that they did not. From our perspective, additional Fed easing will not help increase equity market valuations. We think policymakers should trust the markets more.