Thursday, January 26, 2012

The Fed, monetary policy and economic growth

The Federal Open Market Committee (FOMC) of the US Federal Reserve is clearly open to the concept of further monetary accommodation. In this mornings announcement the committee extended the period over which they expect to keep the Fed funds rate at “exceptionally low levels” out to late 2014. They are also clearly open to further quantitative easing.

In the accompanying economic projections the committee lowered the forecast range for GDP growth to 2.2-2.7% in 2012, down from a range of 2.5-2.9% in November. That’s still a tad higher than our 2%, but they’re getting closer.

We think they are still too optimistic further out with 2.8-3.2% growth expected in 2013 and 3.3-4.0% in 2014. We are quite happy with the view that trend growth in the US is around 2% per annum, reflecting largely ongoing household and government deleveraging.

Their core PCE inflation forecasts are broadly in line with our expectation of a modest easing in core inflation pressure over the next few months, but not significantly so; they have a forecast range of 1.4-1.8% for 2012.

They also provided target Fed funds rate targets for 2012-14. Some FOMC members expect to see an increase in the Fed funds before 2014, but that’s not surprising given there are some dissenters of the current accommodative stance on the committee.

The surprise for me was the cluster of committee “longer run” Fed funds expectations at around 4.25%. We need to be careful here with terminology. In the notes accompanying the forecasts the Fed talks about these longer term projections being the level the committee member expects the rate to converge to over time, “maybe in 5 or 6 years”.

4.25% seems to me to be far too high to be a neutral cash rate: we would put that closer to 3%. Perhaps our long-term is different to theirs! Our rationale for lower US interest rates over time is that we are going to see a long period of fiscal austerity. A persistent negative fiscal impulse takes the pressure off the amount of work monetary policy has to do to keep inflation in check. Time will tell.

Whether the Fed goes down the path of another round of quantitative easing will be dependent on how the data plays out over the next few weeks and months.

The hurdle for QE3 is higher than it was for the previous two episodes of QE. We expect the Fed to undertake the same rigorous cost benefit analysis they undertook for QE2 (remember Bernanke’s Jackson Hole speech in 2010??). QE1 stacked up on the rationale of restoring financial stability; QE2 was about avoiding deflation as annual core inflation dipped under 1% in mid 2010 and looked to be heading lower.

Here’s where I have a problem with QE3. If QE3 is about building a stronger recovery and restoring full employment, I’m not sure it’s going to pass the cost benefit test. Restoring stronger economic and more robust jobs growth in an environment of significant structural change isn’t just a monetary policy problem: it’s a broader policy challenge. In short, I think the link between QE and stronger GDP and jobs growth is, at best indirect and at worst, weak.

That doesn’t preclude a more targeted QE: perhaps a purchase of Mortgage Backed Securities aimed at helping create greater stability in the housing market. More will be revealed when we see the minutes of the meeting which will be released in about 3 weeks. Watch this space.