By Steven C. Johnson
NEW YORK (Reuters) - Whether the Federal Reserve likes it or not, its unprecedented monetary polices over the last few years have conditioned the financial markets to expect a helping hand when the going gets tough.
That's why all eyes will be on Ben Bernanke, the central bank's chairman, when he speaks Friday at the Fed's annual symposium in Jackson Hole, Wyoming.
With the stock market mired in a month-long slump and both the U.S. and euro zone economies in danger of sliding into recession, investors are bracing for a possible repeat of last year's performance, when Bernanke hinted the Fed would act if conditions deteriorated.
Two months later, the central bank began pumping $600 billion into the financial system through direct purchases of Treasury debt, a second round of stimulus that markets dubbed "QE2."
While the jury's still out on how effective these purchases have been, few are ready to rule out QE3 entirely.
Following is a look at what the Fed could do.
KEEPING OPTIONS OPEN
Wyoming may conjure up images of the American Wild West, but markets aren't expecting Bernanke to ride into the mountain resort with guns blazing -- at least not yet.
While the economy has taken a turn for the worse -- growth ground to a halt in the second quarter and nearly flat-lined in the first -- there's a sense that the Fed will want to wait a bit longer to assess the impact of its past stimulus.
Other Fed policymakers have sought to downplay expectations of an imminent QE3 announcement. St. Louis Fed President James Bullard was quoted in Japan's Nikkei newspaper saying that while the Fed could buy more bonds if the economy weakened, the time was not right for such a move.
"Going into Bernanke's speech at Jackson Hole, people are positioned for a significant shift in policy. (But) we think financial market conditions have to deteriorate even further for more QE3," said Simon Derrick, head of currency research at Bank of New York Mellon.
Nonetheless, traders are still expecting Bernanke to signal in some shape or form that he hasn't run out of bullets and could start shooting again if need be.
"Based on our conversations with clients, we believe investors would be very surprised if the speech did not include a discussion of asset purchases," strategists at Goldman Sachs wrote in a note to clients.
They said this could involve the Fed reinvesting proceeds from maturing assets into 10- and 30-year Treasuries to hold long-term interest rates low.
"I think we'll see (QE3) because America needs growth, but I don't think we'll necessarily get it on Friday," said Neil Dwane, chief investment officer for Europe at RCM.
Current market moves reflect this. While still down about 15 percent from late July, the S&P 500 rallied smartly Tuesday and the dollar has struggled against major currencies.
More stock market gains could be in store if Bernanke gives a strong hint of future action. After Bernanke's speech last August, the S&P 500 began a rally that took it up nearly 25 percent by May 2011.
LAUNCHING QE3 NOW
Pulling the trigger now would have the element of surprise going for it and might spark the most aggressive market moves.
There's been some talk in bond market circles that the 10-year yield's dip below 2 percent reflected a pricing in of QE3, though those moves probably had more to do with recent dismal jobs, manufacturing and growth data.
Still, there are impediments to launching QE3.
For one thing, Bernanke already caught investors off guard earlier this month and slowed a market rout when the Fed pledged to keep interest rates near zero until at least 2013.
Steven Bell, director of GLC Ltd, a global macro hedge fund in London with $1 billion in assets, also noted that higher inflation may make the Fed cautious. "We have core inflation going up," he said. "It may be low but it's still going up."
Political opposition is also on the rise. Texas Governor Rick Perry, a candidate for president, even said he would consider it "treasonous" if Bernanke "prints more money between now and the election" in 2012.
That populist anger stems partly from the fact that Fed policies have done little to increase hiring or spark a housing market recovery.
"The history is $600 billion (in bond purchases) hasn't really made any difference to the U.S. economy," Dwane said. "It's still where it was when he was talking about it last August: nearly in recession."
If QE3 fails to boost growth or stokes inflation, markets may wish the Fed had done nothing.
"Investors are becoming more cynical," said Jack Ablin, chief investment officer at Harris Private Bank in Chicago. "Central bankers and governments seem to playing the role of the Dutch boy trying to plug holes in the dike."
MUM'S THE WORD
A humdrum speech that neither announces plans for QE3 or even hints at the Fed's willingness to act is probably the most unlikely scenario, as far as markets are concerned.
If Bernanke did go that way, it could signal that the hawks were gaining the upper hand. Three Fed policymakers voted against extending the zero interest rate pledge to 2013 and have argued that the Fed cannot do much more to boost growth.
Fred Dickson, market strategist at D.A. Davidson & Co, noted that policy remains very loose even without QE3. In addition to holding rates near zero, the Fed has said it will reinvest the proceeds of maturing assets on its "extraordinarily large" $2.8 trillion balance sheet.
"So they have a stealth QE3 policy in place already," he said.
No mention of future easing would likely hurt stocks but should spark a short-term dollar rally. Treasuries would likely fall as expectations of more Fed support faded.
(Additional reporting by Jeremy Gaunt and Simon Jessop in London and Gertrude Chavez-Dreyfuss in New York; Editing by Dan Grebler)