Setting the Stage for an Expansion of Quantitative Easing

by: Tim Duy

The game is on. The relatively weak data flow in recent weeks, culminating with the clearly subpar GDP report, has combined with rumblings from the Federal Reserve that yes, we can do more. The net result is growing expectations that additional easing will occur sooner than later. As early as next week, in fact. Logically, the story hangs together reasonably well except for one key ingredient - the top dog, Federal Reserve Chairman Ben Bernanke, does not appear overly concerned with the economic outlook. But the chatter is becoming almost undeniable. Someone is sourcing the press to believe that a policy change is imminent. And Fedspeak aside, that source cannot be ignored.

Hat tip to Calculated Risk, for seeing this CNBC report Monday:

Japan's Nomura has become the first investment bank to predict the Federal Reserve will begin to ease monetary policy following the recent slowdown in growth in the world's biggest economy.

The deterioration in expectations for growth and inflation argues for an easing of monetary policy, Paul Sheard, the global chief economist at Nomura, wrote in his latest report.

"We expect the Fed to at least stop the passive contraction of its balance sheet," he added.

More than one analyst recognizes the Fed's policy to allow mortgage assets to mature from the balance sheet (or as they are prepaid) as contractionary. A small step forward would be to acquire an offsetting amount of Treasuries as mortgages mature, thus at least holding policy steady. The report continues:

"Perceptions about sustainability are not binary, but lie along an unobservable continuum. A concerned and forward-looking policymaker would presumably take action some time before the economy had irreversibly slipped from sustainability," Sheard wrote.

"We now believe that current conditions have moved policymakers into action and that the FOMC will adopt a more accommodative stance at its 10 August meeting," he added.

The Fed is likely to stop shrinking its huge balance sheet for the moment, a subtler form of easing than just buying assets again, according to the research...

..."To the extent that the size of the Fed's balance sheet matters, this, in effect, amounts to a gradual tightening of monetary policy. Further shrinkage of its asset holdings now seems inappropriate in light of downside risks to growth," he explained.

"We therefore think the committee will return to the explicit language of early 2009, in which it articulated a commitment to 'keep the size of the Federal Reserve's balance sheet at a high level,'" he added.

The idea is pushed even further in Tuesday's Wall Street Journal:

Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.

This is relatively strong language - strong enough, in fact, to imply that it is already a done deal. Why source a piece to raise expectations when you know you are going to dissappoint?

The basic - and reasonable - argument is that risks are now sufficiently weighted to the downside to justify, in the minds of monetary policymakers, an easier policy stance. And holding the balance sheet steady could be a middle ground for opposing camps in the FOMC. Still, while policymakers have shaded down their growth forecasts, they appear relatively at ease with the current level of downside risk. Bernanke's basic outlook today:

After a precipitous decline in late 2008 and early 2009, the U.S. economy stabilized in the middle of last year and is now expanding at a moderate pace. While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth. In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.

Notably, he again highlights his expectation for stronger household spending despite the consumer slowdown evident in the latest GDP report. In other words, he still anticipates that the private sector will pick up where the public sector leaves off. He also reiterates the dismal labor market picture:

Importantly, the slow recovery in the labor market and the attendant uncertainty about job prospects are weighing on household confidence and spending. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, an improvement but still a pace insufficient to reduce the unemployment rate materially. In all likelihood, significant time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects.

Notice that he offers no reason to believe that he has the power to change the state of the labor market. He simply takes a depressingly long wait until unemployment rates decline meaningfully as given. And as far as long-term unemployment, interesting and worrisome, but not much we can do about it. As far as disinflation:

Inflation has been low, with consumer prices rising at an average annual rate of about 1 percent in the first half of this year, and we anticipate it will remain subdued over the next couple of years. Slack in labor and product markets has damped wage and price pressures, and rapid productivity increases have helped firms control their production costs. Meanwhile, measures of expected inflation generally have remained stable.

No mention of further disinflation, just subdued inflation. And, critically, no concern that inflation expectations have taken a turn to the downside. I think that such a turn would prompt further action, but in their mind it hasn't happened.

In my opinion, Bernanke offers a reasonable optimistic assessment of US growth, optimistic at least compared to those of us worried about a protracted period of weakness. He just doesn't sound like someone concerned enough to push on the economic gas.

And, of course, we also have the ever colorful Dallas Fed President Richard Fischer. Paul Krugman has the analysis. In short, Fischer -

  1. is comfortable with current inflation forecasts,
  2. views Administration-induced uncertainty as the chief impediment to economic growth, and
  3. is very worried that additional asset purchases would be akin to deficit monetization.

A relatively right-winged approach to policy. One wonders to what extent Bernanke shares his views. It is often easy to forget that the Fed chief is a Republican.

At the other end of the scale is the door opened by St. Louis Federal Reserve President James Bullard. Similar to Fischer, Bullard likes to talk, but at least retains intellectual coherency. From Bloomberg:

“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released yesterday about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

Is this, however, a call for an imminent policy shift? Bullard continues:

“The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away,” Bullard said to reporters on a conference call yesterday. “Suppose we get another negative shock, another surprise. We have to be prepared in that event to have a plan in place to do something."

Again, his basic outlook is relatively sanguine. He is looking for another negative shock. But how big does that shock need to be? I don't think we have seen it yet.

Note to that Bullard is laying the groundwork to avoid a discussion on extending or terminating the "extended period" language from the FOMC statement:

“The academics will tell you what you have to do is sort of dump interest-rate targeting and switch to something else,” he said. “In the policy debate, that is not really happening. So we need a sharper departure from interest-rate targeting if we are going to get out of this problem.”

I think this is a good interpretation:

Bullard’s stance aims to bridge the gap between two camps at the Fed, said Vincent Reinhart, a former Fed monetary-affairs director. Bernanke is in one group believing that the path of short-term rates is important, while Kansas City Fed President Thomas Hoenig is among officials uncomfortable with the “extended period pledge,” Reinhart said.

I am not particularly confident, however, that Hoenig will embrace a fresh round of asset purchases, extended period pledge or not. One point of worry:

Bullard, who has voiced concerns with the extended-period language since early March, said during the call he wanted to spark debate and his preference has been not to dissent.

Is he seeking to spark debate or generate publicity for himself? If the latter, is he leading us to a premature policy conclusion by so vocally identifying his preferred policy choice? I admit to being concerned that Bullard is leading market participants to expect more sooner than Bernanke is willing to deliver. In any event, Bullard is setting the stage for an expansion of quantitative easing. The most we will get next week is holding steady on the balance sheet.

Bottom Line: The weak GDP report should, on the margin, push the Fed toward further easing. But Bernanke's speech Monday, like his testimony two weeks ago, did not indicate much of a push at all. And a credibly sized contingent of policymakers appears to be dead set against additional easing. On the other side, you see chatter, largely anonymously sourced, about additional easing policies the Fed could pursue. Is this contingent trying to manipulate expectations to push the Fed into additional action? Regardless, a straightforward interpretation is this: The FOMC has downgraded its growth expectations slightly, and needs to lean against that with a small - possibly more symbolic than anything else - shift to hold the balance sheet steady and prevent premature easing. It is not clear that we are getting this from publically available Fedspeak, especially from Bernanke, but the press seems increasingly certain. Still, any handicapping might simply be premature as we look forward to Friday's employment report. A game changer, or just another indication that the economy has settled into a subpar growth path, pretty much what the Fed already expects and is not acting on?