Wednesday, June 15, 2011

What are the Chances of QE3?

The recent run of poor US economic data has raised the inevitable question of the prospects of seeing a third round of quantitative easing, or QE3. That question is being given extra currency given the imminent conclusion of QE2 this month.

QE2 was introduced because the Federal Reserve was concerned about its lack of progress towards meeting its dual mandate of full employment and price stability. At the end of last year, when QE2 was being considered, the unemployment rate was over 9% and there was little in the way of discernible signs that the labour market was improving.

On the inflation front, the annual rate of increase in the core Personal Consumption Expenditure (PCE) deflator, the Feds preferred inflation gauge, had fallen to what was to be its low point of 0.7%.

Seven months further on and the economy appears to be weakening again. In his most recent speech last week, Federal Reserve Chairman Ben Bernanke admitted the recovery had suffered a “loss of momentum” and was proving to be “frustratingly slow”. Much of the responsibility for the slowdown over the last few weeks was given to the weather, high commodity prices and global supply chain disruptions following the Japan earthquake and Tsunami, all factors that Bernanke believed would prove to be transitory. We agree.

In the meantime the unemployment rate, following a brief period below 9%, is back to 9.1%. After a series of three months of solid but unspectacular gains in employment, the most recent data for May was disappointingly soft. That’s in line with the general weakness in the activity data.

On the positive side, there is a persistent trend now of increases in private sector employment. The principal drag on jobs growth is the government sector which is cutting employment as predominantly State and local governments get budgets back to a more sustainable footing. That will only gather momentum as Federal government cuts start to impact.

It is, however, the inflation picture that has changed most dramatically over the last few months. When the Fed was first considering implementing QE2, the annual rate of increase in the core PCE deflator was around 1%. However, using a more near term measure, the 3-month annualised rate of increase was only around 0.3%. The Fed would have taken that as a sign that the annual rate of increase was going to decline further, indeed it bottomed out at 0.7% in the year to December 2010.

That annual rate has now moved back up to 1.0%. That doesn’t sound like much of an increase, but consider this: the 3 month annualised rate of increase has now risen to 1.9% for the three months to April. The Fed will now be taking that as a sign that core inflation is headed higher. Let’s be bold: Deflation is dead.

We think the turnaround in inflation is sufficient cause to discount the possibility of QE3. Sure the labour market hasn’t made the gains we would have liked to see and the rate of overall economic growth is slow, even allowing for the recent disruptions. But Bernanke made another telling comment in last week’s speech: “monetary policy is not a panacea”. In other words: economy - heal thyself.

We believe QE3 is unlikely at this point. It is possible to construct a case for QE3, but later. You will recall our view that fiscal consolidation will do a considerable amount of the “de-stimulus” work needed, when the time is right. That takes the pressure off the work that monetary policy will have to do. There is a possibility that fiscal consolidation becomes too big a strain for what could still be a fragile economy. Then, it seems to me, the time may be right for QE3. But that’s probably a 2013 story.