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Weekly Economic Commentary

 
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Fed Preview: Time to Forge Ahead

September 10, 2012

Download PDF Version

Summary: Look for the Federal Reserve to embark on a new round of quantitative easing next week.

I got home at about 8 one evening last week, and it looked like a bomb had gone off inside my house. The shrapnel included empty pop cans, open bags of snacks, and scores of used napkins. The sink was filled with dirty dishes, and laundry (clean, or dirty?) was strewn about the floor. No one was home, leading me to suspect that the explosion had done them all in.

Fortunately, my grief was short-lived; the missing filed in about fifteen minutes later. While glad that they hadn’t been lost, I confronted them over the sorry state of affairs in our home. The responses: not my job, I thought so and so was going to do it, that’s not my fault, and I didn’t have time to get around to it. Rather than sort out this entanglement, I meekly cleaned up the mess and then retreated to the basement to mutter to myself.

Sometimes, it’s best to address troubling situations before assessing responsibility. That may be the best posture for the Federal Open Market Committee, which gathers this coming Wednesday and Thursday to decide on the future course of monetary policy. While they have every right to expect more help from Congress and from European policy makers in trying to improve economic performance, they may not be in a position to wait for those groups to act.

Here is a matrix which looks at the pros and cons of the most likely outcomes, along the subject lines that the Committee will likely discuss.

DGC 9/10/12

 Despite being wrong in this supposition before the last FOMC round, we think that the Fed will opt for a modest extension of its quantitative easing program, and lengthen the duration of time over which short-term rates will be kept near zero. As we discussed earlier this summer, we don’t think that the Fed will lower the interest rate it pays on excess reserves (IOER).

Here are the key factors we think will carry the day.

  • We believe that slow job creation and a good fraction of declining labor force participation is due to soft growth, and not skills mismatches. Ed Lazear’s Jackson Hole paper takes this apart at the micro level, and Chairman Bernanke’s observation that unemployment has returned to the 5%-6% range no matter the depth of recession or industrial transition is a powerful macro observation.
  • While the impact of QE III may be more limited than its predecessors, we expect it to have a favorable impact on fundamentals and market psychology.
  • Action to conclusively address fiscal issues in the U.S. and Europe may be months off, presenting risks to the outlook and creating an urgency for the Fed to act while it can.

It is difficult to hazard a guess on how large the new program might be. It must be sizeable enough to be meaningful, but not so large as to risk the support of swing voters on the FOMC. (Proposals for open-ended QE would likely encounter resistance from several participants.) Our sense is that $400-$500 billion should be about right.

We also expect the group to communicate to the markets that short-term interest rates will be kept near zero for even longer than previously promised. Some have suggested moving the date into 2015, but a lot can happen in two and a half years. The Fed’s discussions about the proper way to communicate its intentions to the market may result in a different sort of post-meeting statement, one which keys action more closely to macro conditions.

When I left Chicago yesterday for meetings with clients here in New York, my house was reasonably tidy. I worry, though, what it might look like when I return. If it’s bad, I may end up being the one that goes AWOL for a while.

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The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.
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