Wednesday, August 24, 2011

Waiting for Jackson Hole…again.

Just as we were 12-months ago, the market is again eagerly anticipating Federal Reserve Chairman Ben Bernanke’s annual speech from Jackson Hole (scheduled for August 26). It was in last year’s speech that the Chairman flagged the introduction of the second program of quantitative easing (QE2) which was subsequently announced in November 2010.

It seems to us, however, that conditions in 2011 are somewhat different to 2010. In the third quarter of 2010 the core personal consumption expenditure (PCE) deflator was running at an annual rate of less that 1% and falling. At that point the risk was a period of debilitating deflation. In 2011, the risk of deflation has receded significantly: core PCE is at 2.1%. Some would argue it has been eliminated, unless you believe the US economy is headed for another deep and protracted recession (not our view).

In the 2010 speech, Bernanke was at pains to point out that before deciding to implement QE2, the Fed would undertake a rigorous cost/benefit analysis before implementing. They obviously came out on the side of the benefits being greater than the costs. But it has not been clear to me exactly what the benefits have been, especially with regard to the real economy. Until recently it appeared the Fed simply increased banking system reserves which ended up as excess reserves on bank balance sheets.

More recently, however, it is notable that US money supply growth has spiked higher. Is this a sign that those higher bank reserves are becoming increased money supply? If that higher money supply becomes loan growth, that is one reason to be somewhat optimistic about the outlook. We will be watching this closely.

So what should we expect from Jackson Hole this week? Not a lot would be my guess. At various times the Fed has flagged other options open to it including cutting the interest rate on excess reserves and extending the maturities of their Treasury holding by selling short-dated maturities to buy longer-dated bonds. They could also commit to a timeframe for keeping the Feds balance sheet unchanged as they did at the last FOMC for interest rates.

The flagging of QE3 would be premature at this point, although he will highlight it as an option for later if needed. I have no doubt the Fed would go down that path were they to think it necessary, it’s just not necessary now. They haven’t come this far to throw in the towel.

There’s still one comment from a recent Bernanke speech that keeps coming back to (haunt?) me. As QE2 was coming to an end in June he said: “Monetary policy is not a panacea.” That's a really big sentence in the context of his speech this weekend. It seems to me he will point out that there is only so much monetary policy can do. Interest rates are low and can’t go much lower and banks have considerable capacity to lend. The building of the new US economy requires a broader policy response and it is just going to take time.