To QE3 or Not to QE3?

by: Robert Sinn

Without boring my readers too much (feel free to skip to the end if monetary policy bores you and you would like to get to the conclusion), I would like to briefly delve into the monetary policy debate in which the Federal Reserve currently finds itself as QE2 draws to a close.

Most economists tend to view the thought of a QE3 with great distaste and deem the odds of the Fed moving forward with another round of quantitative easing in June as highly unlikely. Friday’s speech by Philadelphia Federal Reserve President Charles Plosser on a proposed exit plan from the Fed’s "extraordinary accommodation and nontraditional policies" appeared to ruffle some feathers in the market (a sharp spike in the dollar occurred immediately after the release of the Plosser speech). St. Louis Fed President James Bullard, who was one of the main advocates of QE2 last year, joined Plosser in striking a hawkish tone during a speech delivered Tuesday morning at the European Banking and Financial Forum in Prague, Czech Republic.

The hawkish tone from various Fed presidents comes on the heels of a significant tightening of monetary policy tone from the European Central Bank. Tough talk from ECB President Trichet and other ECB members has caused markets to price in approximately 125 basis points of tightening over the next 12 months and a 41% chance of a 50 basis point hike at the ECB meeting next week. Where did all of this central bank hawkishness come from, and how does Fed Chairman Bernanke feel about it?

With real interest rates currently well into negative territory, the ECB’s recent hawkish tone is not in the least bit surprising, given its single mandate of maintaining price stability. The Fed’s recent hawkishness, however, is a bit more of a surprise; take a look at the most recent FOMC statement, from March 15:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. The recent increases in the prices of energy and other commodities are currently putting upward pressure on inflation. The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations. The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.

Chairman Bernanke has repeatedly voiced his intention to remain focused on improving the employment situation until something resembling maximum sustainable employment is achieved. The FOMC statement from two weeks ago does not lead me to believe anything has changed in this regard.

Bullard made an unexpected hawkish shift when, on March 29, he proposed the possibility of ending QE2 early:

If the economy is as strong as I think it is then I think it may be reasonable to send a signal to markets that we’re going to start withdrawing our stimulus, and I’d start by pulling up a little bit short on the QE2 program.

Despite Bullard’s shift in posture away from the dovish monetary policy camp, he still managed to hedge a bit by outlining four key sources of macroeconomic uncertainty. They are as follows:

1. Turmoil in the Middle East and North Africa and the resulting uncertainty premium in oil prices.

2. The natural disaster in Japan and the damaged nuclear reactors.

3. The U.S. fiscal situation and the possibility of a government shutdown.

4. Continued uncertainty regarding the resolution of the European sovereign debt crisis.

However, Bullard stated that “the most likely prospect is that all four are resolved without becoming global macroeconomic shocks,” and went on to say, “I think it’s still reasonable to review QE2 in the coming meeting, especially this April meeting, and to see if we want to decide to finish the program or to stop a little bit short.” As a non-voting member of the FOMC, Bullard’s opinion has little impact on the ultimate decision made by the FOMC on whether to stop QE2 early or to even go ahead with a QE3.

Philadelphia Fed President Charles Plosser is in fact a voting member of the FOMC, and is more influential than Bullard in shaping FOMC policy going forward. Here is what I believe to be the most important paragraph from Plosser’s statement to the Shadow Open Market Committee last Friday:

To summarize, my preferred operating environment would re-establish the federal funds rate as the primary instrument of monetary policy; shrink the balance sheet and reserves to levels that make the federal funds rate an effective policy tool; and restructure the balance sheet in terms of its composition and maturity structure. Adopting an explicit inflation objective would contribute to the effectiveness of policy and the policy framework and any plan for normalization.

This is a fairly hawkish statement, because Plosser is recommending that the Fed shrink its balance sheet and move to a shorter maturity portfolio largely comprised of treasury securities (40% of System Open Market Account assets are currently housing related i.e. MBS). He goes on to put forth a proposal to sell approximately $20 billion of Fed balance sheet assets per month, which in addition to the natural run-off of maturing assets would serve to shrink the Fed balance sheet by about $50 billion every six weeks.

But wait, Plosser isn’t done yet. He goes on to call for a series of rate hikes (25 bps per FOMC meeting) combined with $125 billion of additional asset sales every six weeks, which would eventually bring the fed funds target rate up to 2.50% and shrink the Fed’s balance sheet by $1.45 trillion at the end of one year. Simply put, the Plosser speech is hawkish; it is not surprising that the dollar spiked on the back of the release of the speech on Friday. You can read the rest for yourself here.

In my opinion, Bernanke, Dudley, et. al. are not likely to go along with Plosser’s exit plan as such a decisive unwinding of the Fed balance sheet (mortgage-backed securities sales) would risk placing too much pressure on a fragile commercial and residential housing sector. The most likely scenario is a completion of QE2 in June, followed by a pause (three-to-six months) to determine the robustness of the economic recovery when challenged to stand on its own legs.

Perhaps Plosser’s exit plan will come into play by year end or, more likely, in early 2012. However, I wouldn’t rule out QE3 entirely (and a further expansion, not contraction, of the Fed’s balance sheet); instead I have downgraded my estimate of the likelihood of its implementation before year end 2011 to less than 30%.