Sunday, August 7, 2011

Yes to QE3, but not yet

Last week, it is dawning on Mr. Market that the US economy is starting to look weak. Last whis week, John Hussman was discussing the signposts for another economic slowdown. Moreover, ECRI was warning about double-dip concerns this summer (note that they are not calling for a double-dip recession, just rising concerns about a double-dip). In addition, three prominent former Fed officials, namely Brian Madigan, Vincent Reinhart and Donald Kohn, called for the Fed to take a second look for another round of bond buying.

In view of these worries about slowing growth, is the Fed likely to ride to the rescue with another round of quantitative easing?

QE3 Tripwires
Tim Duy, who is one of the better Fed watchers in the blogosphere, outlined the criteria for QE3 here. In Ben Bernanke's testimony to Congress on July 13, 2011, the following snippet from Bernanke's testimony got the markets all excited about the possibility of QE3 [emphasis added]:
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally.
When economists say "on one hand", you have to see what they say "on the other hand" [emphasis added]:
On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy. Accordingly, the Committee has been giving careful consideration to the elements of its exit strategy, and, as reported in the minutes of the June FOMC meeting, it has reached a broad consensus about the sequence of steps that it expects to follow when the normalization of policy becomes appropriate. In brief, when economic conditions warrant, the Committee would begin the normalization process by ceasing the reinvestment of principal payments on its securities, thereby allowing the Federal Reserve's balance sheet to begin shrinking. At the same time or sometime thereafter, the Committee would modify the forward guidance in its statement. Subsequent steps would include the initiation of temporary reserve-draining operations and, when conditions warrant, increases in the federal funds rate target. From that point on, changing the level or range of the federal funds rate target would be our primary means of adjusting the stance of monetary policy in response to economic developments.
Duy thinks that the criteria for QE3 are economic weakness and deflation risk:
Note the two conditions – persistent economic weakness coupled with deflation risks. The latter was a focus when the Fed initiated QE2, with the lack of such risks guaranteeing the Fed would cease asset purchases at the end of June. Bernanke made clear the focus on deflation in his most recent press conference.

Let's go to the tape
So what are the deflationary risks and, conversely, inflationary expectations? As they say in the sports shows, let's go the tape...
One of the Fed's most closely watched inflation indicators is Personal Consumption Expenditure, or PCE. The Dallas Fed publishes a trimmed mean PCE series, which is a measure of core PCE, or PCE without the volatile components. While one-month PCE did turn negative in the latest June release, note how trimmed mean PCE has been ticking up in the last few months at the 6 and 12 month level (circled). These figures are at best mixed and not friendly to the initiation of QE3.
In addition, Friday's Non-Farm Payroll came in ahead of expectations. Though the headline NFP jobs gain of 117K jobs still indicates a weak economy, it is not showing signs of deterioration (and deflation).
What about inflationary expectations? Don't forget one of the Fed's mandates is to control inflation. Tim Duy made the following comment after the jobs report Friday:
The implied inflation expectations from the TIPS market is 193bp and 225bp at the 5 and 10 year horizons, respectively. Still well above last summer's lows. The Fed has repeatedly argued they can't do anything about growth, but can fight deflation. But this doesn't appear to be a strong deflationary signal. This too argues against significantly policy shifts.
What about other market based indicators of inflationary expectations? Take a look at the price of gold. In July the yellow metal rallied about resistance at 1,500 and is in a solid uptrend. Is this what deflation looks like?

Despite the pain suffered by the financial markets, I don't believe that the Fed will ride to the rescue with a QE3 program in the immediate future. They will undoubtedly act - but later, when the damage is done to the markets and the economy.
Understand how Fed governors think. These people are mostly academics, charged with steering the most powerful central bank in the world. Academics are conservative by nature and want to wait for the evidence to come in before acting. After all, you don't want to over-reacting on minor blips in the data, do you?
The Greenspan Put vs. the Bernanke Put
Also put yourself in Bernanke's head. His academic reputation was built on the study of central bank action during the Great Depression. This is probably a little voice in his head telling over and over again, "Don't let another Great Depression happen on your watch." As a result, we have the Bernanke Put.
Contrast that with Alan Greenspan's background, who had more experience on the Street as a forecasting economist. His bio from Wikipedia states that before he went to the Federal Reserve, he had extensive real-world (as opposed to academic) experience:
During his economic studies at New York University, Greenspan worked under Eugene Banks, a managing director at the wall street investment bank Brown Brothers Harriman, working in the firms equity research department. From 1948 to 1953, Greenspan worked as an economic analyst at The National Industrial Conference Board, a business and industry oriented think-tank in New York City. From 1955 to 1987, when he was appointed as chairman of the Federal Reserve, Greenspan was chairman and president of Townsend-Greenspan & Co., Inc., an economic consulting firm in New York City, a 33-year stint interrupted only from 1974 to 1977 by his service as Chairman of the Council of Economic Advisers under President Gerald Ford.

In the summer of 1968, Greenspan agreed to serve Richard Nixon as his coordinator on domestic policy in the nomination campaign. Greenspan has also served as a corporate director for Aluminum Company of America (Alcoa); Automatic Data Processing, Inc.; Capital Cities/ABC, Inc.; General Foods, Inc.; J.P. Morgan & Co., Inc.; Morgan Guaranty Trust Company of New York; Mobil Corporation; and The Pittston Company. He was a director of the Council on Foreign Relations foreign policy organization between 1982 and 1988. He also served as a member of the influential Washington-based financial advisory body, the Group of Thirty in 1984.
Greenspan's approach as Fed Chairman was to stimulate whenever he saw signs of weakness - and he was far more market savvy than Bernanke. Therefore the Greenspan Fed tended to be more proactive and tended to get ahead of events. The Great Moderation was the result of the Greenspan Put - and those policies worked well, until they went overboard with the stimulus (and we are still paying the price for those policies).
In essence, that's the difference between the Greenspan and Bernanke Fed. The Greenspan Fed would be acting now with another round of QE as it had a history of getting ahead of market events. The Bernanke Fed is more cautious and will only act when the economic evidence is fully in - which likely means Q4 at the earliest.
I don't expect any form of QE to be announced this week. The most we can expect from the Fed is for them to moderate their language to hint that they are allowing for some signs of weakness (which they'll "monitor") and hint at another round of QE.


WSM said...

"What about inflationary expectations?"

Take a look at 10-yr UST yields.

And be careful about selectively choosing data that fits your premise.

And even in choosing gold to support your inflation expectation, it should be noted that gold has done well in deflationary environments historically.

WSM said...
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