Friday, July 27, 2012

QE3 – a fine balance (and some very helpful comments from Mario Draghi)

The US Federal Reserve meets next week: market attention will focus on whether the Fed is ready to pull the trigger on more quantitative easing (QE3).  We think it’s still a line ball call whether the Fed does more; furthermore next week might be tad too early to expect action.

It was in Ben Bernanke’s 2010 speech from the annual Fed symposium in Jackson Hole that he signalled that QE2 was on the way.  In that speech he also emphasised the rigorous cost-benefit approach the Fed was taking to its unconventional monetary easing.   Yes, quantitative easing is still unconventional!

In the case of both QE1 and QE2, the benefits outweighed the costs.  The first QE program in 2008 was about restoring market functionality.  QE2 was announced at the time in which the annual rate of core inflation was on a steep downward trajectory and under 1%: deflation was to be avoided at all costs.  However, for QE3 the cost benefit analysis is more finely balanced.

The direct impact of quantitative easing on the real economy is far from certain.    A lower exchange rate is certainly helpful for the necessary rebalancing of the US economy towards exports.  Apart from that, we think the greatest real economy impact is on inflation expectations rather than final demand.  Right here right now the bigger problem is the weakness in final demand, not inflation.  While US headline inflation is currently falling, core inflation is comfortably stable over 2%.

Along with its dual mandate of price stability and full employment, the Fed also has a responsibility to ensure the efficient functioning of markets.  It is this that is giving cause for contemplation especially at a time Bernanke himself has conceded that more QE faces diminishing returns.  In the June FOMC minutes some Fed members were concerned that continued purchases of long-term securities may “lead to deterioration in the functioning of the Treasury securities market that could undermine the intended effects of the policy.”  It is likely the Fed has room to institute more quantitative easing, but they are right to be considering how much is too much.

The Fed also needs to be mindful of the risks at the other end of the QE experiment and the potential for damage to its inflation-taming credentials.  The QE exit strategy is yet to be determined, let alone deployed.  The more QE put in place, the more there is to be exited.  That makes the timing of the start of the exit strategy quite critical to reduce the risk of unintended inflation consequences at the other end.

More QE is not the only option open to the Fed; they will be contemplating other tools.  They could extend the “extended period” over which interest rates are expected to remain low.  Some members of the FOMC also appear to be quite taken, as we are, with the UK’s recent “Funding for Lending” program.  That approach seems to us to be likely to have a more direct impact on lending to households and businesses and real economic activity than straight quantitative easing.  There is also speculation the Fed may make greater use of the discount window.

Those of you who have read our July edition of Quarterly Strategic Outlook will recall a discussion on another problem with continued reliance on central banks to fix the problem of disappointing economic growth: central banks can’t fix structural problems.  Our concern is that continued (and increasingly ineffective) monetary policy action is lulling policy makers into a sense that something is being done, just when it is a broader predominantly supply-side policy response that is required.   That complacency will lead to continued policy procrastination and paralysis.

We think QE3 is currently a 50:50 bet.  Weak jobs, weak manufacturing and weak retail sales won’t be ignored, but we think the Fed will be prepared to wait for a bit more data before deciding whether the benefits outweigh the costs.  Watch this space.

Footnote on Europe: Comments from ECB President Mario Draghi over night were very helpful.  Draghi said the ECB will do “whatever it takes to preserve the Euro, and believe me it will be enough”.   As we have discussed previously we see bond purchases by the ECB as being justified on monetary policy grounds because the usual monetary policy transmission mechanism has broken down.  Bank funding costs are not currently determined by the ECB overnight interest rate, they are determined by the funding costs of the country in which they are based.  In particular Draghi said: “To the extent that the sovereign premia hamper the functioning of the monetary policy transmission channels, they come within our mandate”.  That’s good stuff.  To us that means a stepping up of the Securites Markets Progamme rather than full QE, but all that’s left to say is just do it.