The View From Here

Our analyses of topical issues relating to the economy and financial markets.

FOMC Preview: Christening QE III

July 27, 2012

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

My family's summer vacation has to be scheduled between the end of my children’s summer camps and the start of school.  With a varsity athlete in the family, that window is very short.  And, as luck would have it, the American economy and world markets always seem to be in turmoil during that interval.  I can't catch a break.

So, I'm filing this note from Door County, Wisconsin.  It’s an idyllic part of the Midwest: beautiful shores, quaint shops, and grand sunsets.  In a sign of the times, the local library has become the most popular spot on the peninsula; I'm in a crowd of people who are taking advantage of that rarest of Door County commodities: wi-fi access. Pretty sad.

The Federal Open Market Committee will be meeting next Tuesday and Wednesday to decide on the future course of monetary policy.  Here is a matrix that looks at the pros and cons of the most likely outcomes, along the subject lines that the Committee will likely discuss.

QE III Stand Pat
US economic activity seems to be faltering. Real GDP grew at an annual pace of just 1.5% in the second quarter, well below potential (which the Fed’s long-term forecast suggests is around 2.5% in the current environment). Job creation has diminished, and broad measures of unemployment have gotten worse. Retail sales have softened. Analysts suggest rising risk of recession. The time to use dry powder is now. Real GDP growth of around 2.2% for the past four quarters is not a dire outcome. Further, we are in a classic liquidity trap. Large fractions of past monetary easing remain parked as excess reserves with the Fed. Borrower surveys suggest that demand for credit is very modest, and supply is limited by banks seeking to preserve capital. Adding more accommodation would have the character of pushing on a string.
Inflation is at a modest level, and slower growth should increase resource slack. Inflation expectations, as measured by surveys and market indicators, remain well contained. Should price pressure return, monetary policy can respond. M2 has been growing at a 10% annual pace.  Some may stop there in arguing against QE III.  But to take one step further, reversing quantitative easing will be a complicated process that could be the subject of intense political pressure.
Additional large scale asset purchases would provide direct aid to the housing market, which remains challenged in spite of its recent gains.  Lower mortgage rates could boost sales or enhance refinancing, which would add to spendable income. The housing sector can’t be saved with lower rates.  Normalized lending terms, limited mortgage markets, and a host of policy uncertainties are conspiring to limit progress.  Spending gains from additional refinancing would be small.
What some describe as a fiscal cliff is actually a mountain range.  The Federal precipice is defined by the coming expiration of stimulative elements and forced sequestration.  The other canyons are formed around state and local budget valleys, which were carved from slow growth in net revenue and heavy pension obligations. It isn’t practical or possible for the Federal Reserve to compensate for all of the shortcomings of fiscal policy.  Attempting to do so would bring the Fed into closer political range of its critics.  Congress, once reverential towards our central bank, has shown an increasing willingness to meddle in monetary and regulatory affairs.
Events in Europe remain worrisome, despite the statements of support from national and monetary leaders.  The Continent’s recession is hindering exports from the US and from developing countries.  The Continent’s banking crisis is fomenting risk aversion and threatens contagion to other markets.  Another step from the Fed would have fundamental and symbolic value. Most would agree that the Federal Reserve is not in a position to solve Europe’s problems.  Swap lines are in place to mitigate potential cross-border liquidity problems should they arise.  Interestingly, the flight of capital from risk assets into Treasury securities has lowered long-term rates more effectively than quantitative easing has, potentially making further Fed action redundant.

All things considered, we think that the FOMC will opt for a modest extension of its quantitative easing program, initiating what some have called QE III.  As we discussed earlier this week, 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.

  • The Fed's dual mandate calls for them to work towards maximum sustainable employment.  We seem to be moving in the opposite direction of that aim.  Inflation seems to be well-contained, allowing room to address the jobless issue.
  • The paralysis in Congress, likely to last for the balance of this election year, does place additional pressure on the Fed to be accommodative.  It might be tempting for the FOMC to throw up its collective hands in frustration, but quantitative easing has proceeded for three years now in the face of fiscal gridlock.
  • Even if recent statements from Europe are followed by real action, it will take some time for European economies and banks to recover from what they have been through.  The global picture will therefore remain a headwind for U.S. growth.

There will no doubt be dissent on this decision from some corners of the table.  But there should be a core of support that can carry the day.

This will be a close call, so the risk of being incorrect is certainly high.  I’m therefore tempted to research this even more deeply, but my family has their faces pressed angrily against the library window.  Time to shut down and enjoy the scenery.

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.