"Given the recent bond offering by California appears to have been given the cold shoulder by the public, might they turn to the Fed?" asks Art Cashin, director of NYSE floor operations at UBS Financial Services, in his widely-read morning note to clients. Cashin has often referred to a 2002 speech by Bernanke on deflation, where the Chairman hints at buying all kinds of securities as a playbook for the current crisis.
"The Fed has the authority to buy foreign government debt, as well as domestic government debt," said then-Governor Bernanke, to the National Economists Club in Washington D.C. "Because some of these alternative policy tools are relatively less familiar, they may raise practical problems of implementation and of calibration of their likely economic effects. For this reason, as I have emphasized, prevention of deflation is preferable to cure. Nevertheless, I hope to have persuaded you that the Federal Reserve and other economic policymakers would be far from helpless in the face of deflation, even should the federal funds rate hit its zero bound."
Municipal bonds, funds and ETFs have gotten slammed the last two weeks as states and counties sell more bonds to cover year-end spending. A possible compromise on the Bush dividend and capital gains taxes has also caused some investors to flee this sector since its attractiveness is partly based on its function as a tax shelter.
"The Fed could buy munis and it would be rather like the ECB buying Greek debt," said Patty Edwards of Trutina Financial. "With the tax cuts being extended, munis won’t have the same demand that they would have if tax rates jumped. And that could lead to issues for the muni markets."
Edwards and other money managers have said talk of this move has been around for a while and exists today even with the current backlash against "QE2". Notable economists wrote an open letter to the Fed last week arguing against the ongoing buying of $600 billion in Treasury securities that the FOMC announced earlier this month. Republican Congressman, both current and incoming, have been in up in arms about the move, becoming unlikely allies with central banks from China to Brazil, who have accused Bernanke of essentially exporting inflation to their countries.
"With election results, it’s going to aggravate many to bail out states, but I could see it happening," said Steve Grasso of Stuart Frankel. "My feel is they will have to regardless of political environment."
The PowerShares Insured Cali Muni Bond Fund (PWZ) is down 6 percent in five days, but only down about a half percent today. The iShares S&P National AMT-Free Municipal Bond Fund (MUB) has lost five percent of its value this month.
"We’re a bit away from a crisis feeling in the sector and the recent performance is certainly within the normal boundaries of supply/demand imbalance-driven volatility," said Ben Thompson, who manages $7 billion for Samson Capital Advisors.
Many investors agree with Thompson that it won’t be needed. Some even question the legality for the central bank to even do so.
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John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team.