Fed To Business Cycle: Do You Feel Lucky?
When the facts change, I change my mind as any good trader should (and the best traders furthermore define "facts" as "anything which other people will think is important").
I have been saying that I think QE3 is unlikely, at least in the form of another Large-Scale Asset Purchase (LSAP). The reason for this is simple: QE3 makes no sense. In retrospect we can see that it had no lasting effect on growth. Anticipation of QE2 pushed commodity and equity prices higher (see Chart), but most of the equity gains had vanished by the lows this month (and, anyway, if higher prices don't trigger growth through a "wealth effect," as they evidently didn't, then who wants equities to trade at liquidity-induced richness? Rationally, only retirees and other dis-savers who are net sellers.)
Stocks and commodities normalized to August 27th, 2010.
Indeed, as has been well-documented most of the LSAP money went into excess reserves, where the Fed paid banks to keep it, and money rates sank to sharply negative real rates. And it isn't like the LSAP was without cost. A central bank which buys the net debt of the sovereign issuer is de facto monetizing, and the precedent is dangerous. In short, there are a whole lot of reasons to think that QE2 was a net zero or negative, and really no good reasons to think the effects were salutary. Why in the world would a rational central bank think about doing it again?
And then the FOMC minutes from the August meeting were released today. In contrast to the vast majority of the scores of such minutes that I have read, this one contained some dramatic revelations.
The ones that got the most airplay today were the ones related to QE3, of course. As we already knew, participants at the meeting had "discussed a range of policy tools available to promote a stronger economic recovery in a context of price stability," because the statement released after the meeting said so. What we didn't know was the range of tools discussed and the relative credence given to each of them. This passage is the key one (my comments in brackets throughout):
Participants discussed the range of policy tools available to promote a stronger economic recovery should the Committee judge that providing additional monetary accommodation was warranted. Reinforcing the Committee's forward guidance about the likely path of monetary policy was seen as a possible way to reduce interest rates and provide greater support to the economic expansion; a few participants emphasized that guidance focusing solely on the state of the economy would be preferable to guidance that named specific spans of time or calendar dates. Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. Others suggested that increasing the average maturity of the System's portfolio--perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities--could have a similar effect on longer-term interest rates. Such an approach would not boost the size of the Federal Reserve's balance sheet and the quantity of reserve balances. [This is 'Operation Twist.' It seems to be an article of faith that lower long-term rates would boost activity although we already have record-low long-term rates.] A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions. [As I have been saying for a while, for example here and here, and I still think they ought to do this before blasting away any more on LSAP.] In contrast, some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery, either because the headwinds that the economy faced would unwind only gradually and that process could not be accelerated with monetary policy or because recent events had significantly lowered the path of potential output. [I would love to know which participant said the process could not be accelerated with monetary policy. Hawkish or dovish, almost all Fed officials at least share a cultish faith in the almost-magical efficacy of monetary policy. It's the membership card you have to present to get in!] Consequently, these participants thought that providing additional stimulus at this time would risk boosting inflation without providing a significant gain in output or employment. [Exactly! I know that saying 'exactly!' doesn't add any analysis but I am so flabbergasted to hear this from even an anonymous person at the Fed that I had to say it.] Participants noted that devoting additional time to discussion of the possible costs and benefits of various potential tools would be useful, and they agreed that the September meeting should be extended to two days in order to provide more time.
So, the Fed is considering more LSAP, LSAP with a twist, lowering IOER, or doing nothing. It seems they are biased against doing nothing; ergo, they will eventually do something if economic data suggest (at least to them) that it is warranted. I want to point out that before Greenspan became Chairman, we recognized that business cycles happen and that the central bank's main job - as they learned in the 1970s - was to moderate the growth in the price level (i.e., inflation). Then Greenspan ascended the throne, and declared war on any kind of recession. Every crisis was met with massive (or what we used to think was massive) monetary stimulus. Now, apparently, the Fed believes that they need to add tremendous liquidity just because growth is below potential. Don't we all see that as madness? Either that, or they're preparing to add tremendous liquidity because they perceive a recession is likely, as do I...but in that case, shouldn't they be even more skeptical of the usefulness of adding liquidity, since such a recession would be occurring despite QE2?
But there is no doubt that the leadership of the Fed is in love with printing. This is just nuts, but I now believe that we're likely to see QE3 (although I would be surprised to see it as early as September, the minutes really do open up that possibility - so maybe I was wrong and Bernanke last week really did mean to hint at it).
Even more dramatic was the passage about the low-rate pledge. The Fed at this last meeting changed long-standing policy and stated that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013." I noted here that linguistically, the statement is a mess. The words "are likely" are a statement of probability, which is inconsistent with the absolute "at least" in the time frame. Analysts clearly thought it was a promise, and Minnesota Fed President Kocherlakota made clear on the Friday after the meeting that "exceptionally low" meant 0-0.25%, not something that could be a little higher. Logically, if it was not a promise, then it was vacuous. If "we're going to keep rates low, unless we want to raise them" was what they meant to say, then they wasted everyone's time.
But now we see that that's exactly what they meant. In the passage below I've put the critical part in bold:
In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee's intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting. One member expressed concern that the use of a specific date in the forward guidance would be seen by the public as an unconditional commitment, and it could undermine Committee credibility if a change in timing subsequently became appropriate. Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
So...vacuous it is! The Fed was probably never going to tighten before late 2012 anyway, and the promise to make it 2013 depends on whether they're right about the economy and inflation. Since they haven't been right about the economy since Marmaduke was a pup, that isn't much of a promise.
The FOMC statement was, to me, the most startling part of the day. That is even though it had strong competition today from a truly-abysmal Consumer Confidence figure. Confidence plunged to 44.5, the lowest since early 2009 (see Chart). Among other things, this means that the current economic situation now clearly belongs to the current President even if the last President owned the 2008-09 debacle. At least, consumers experiencing a renewed sense of discouragement are not likely to attribute much of that sense to President Bush. At this point, the Republicans could nominate a ham sandwich and comfortably win the election (and there is some chance they may do so), although of course there is a long way to go until election day 2012!
Consumer Confidence is plunging. Again.
This isn't a political column, and that observation has market consequences: a desperate Administration is likely to propose increasingly dramatic programs similar to the ones which have provided short-term boosts followed by payback dips thereafter (e.g., Cash for Clunkers). These sorts of programs have drawn increasingly skeptical market responses for each one in sequence, as investors have grown tired of both the borrow-and-spend approach and the intensifying conflict that each one engenders on Capitol Hill.
But the jaw-dropping headline decline was actually exceeded by the rise in the "Jobs Hard to Get" subindex, which historically co-moves with the Unemployment Rate (see Chart). "Jobs Hard to Get" is now just barely shy of the highs from late 2009, when the Unemployment Rate hit 10.1%.
Payrolls and Jobs Hard to Get
That doesn't mean that the Unemployment Rate on Friday will rise dramatically. The ongoing decline in the labor force as discouraged workers exit is depressing the measured 'Rate. But the direction seems clear.
Less urgent, but also worth noting, is the fact that Italian 10-year yields are again comfortably over 5%. The ECB had drawn a line in the sand there and appears to be comfortable letting that market slide, but the slide could easily turn back into a rout - keep an eye on it. Spanish yields have also been rising, but not quite as much. Greek yields of course remain near the highs, despite the merging of two large bankrupt institutions to form a larger bankrupt institution (for the life of me I can't understand why two drowning people grabbing each other is helpful to either of them).
Commodities prices, led by energy and industrial metals, reached the highest levels of the month. Along with bad growth data (in the form of Confidence), we get higher commodities prices - a good reminder that commodities prices can go higher even if growth is poor. I keep saying it, and some people keep scoffing. But they're not scoffing in the inflation swap market, where the 1-year inflation swap rose 20-25bps today. The short end of the inflation curve had been very cheap, as I pointed out as recently as last week. It is much closer to fair today!
Tomorrow is unlikely to hold such drama (knock on wood). But the ADP Employment number (Consensus: 100k vs 114k last) ought to be weak. Expectations for the Chicago Purchasing Manager's report (Consensus: 53.3 vs 58.8) should make it harder to surprise on the downside; a consensus print would be the lowest reading since late 2009 and reflect a nearly-stalled manufacturing sector in the Chicago area.
 Despite the fact, I will note, that no policy tool has ever been proven to promote a stronger economic recovery in the context of price stability, and the most-recent experience would seem to suggest that consumers are not terribly subject to money illusion - a necessary condition for growth in the money supply to contribute to real growth.