It is beginning to look like the economy is circling the drain. To be sure, I hate to make too much of one report, but the May employment report comes at the end of a series of bad reports stretching back to nearly the beginning of the year. There looked to be solid hope the recovery was on a better track as 2010 drew to a close, and that momentum appeared to carry through into January. But then we hit a wall.
What wall? Theories abound. Temporary weather and tsnumai induced disruptions for one, but we should be trying to look through such short term events. The crisis in Europe, although to be honest I don’t think this is having much of an impact on the decision making of the average US citizen or firm. I tend to think the rise in commodity prices, particularly oil, was the primary culprit, as consumer spending faltered and businesses struggle to pass increasing costs onto consumers. But what it really comes down to is that we have only had one good quarter in this recovery, and that simply was not enough to provide sufficient resilience to the sheer number of shocks the economy has weathered this year.
And let’s face it, even with that one good quarter, forecasters were still looking forward to a protracted recovery. That, however, did not stop the policy environment from turning remarkably contractionary. The debate in Washington quickly turned to how quickly to cut the deficit, how quickly to withdraw monetary stimulus. All with the goal of assuaging the invisible bond vigilantes, who have apparently been helping drive the 10 year Treasury yields back down to 3%. The turn toward contractionary policy - and monetary policy arguably turned contractionary when Fed policymakers questioned the wisdom of continuing QE2 - is surely one of the shocks that hit the economy.
Will the Fed respond with anything more? Well, if Federal Reserve President Richard Fisher is any indicator, the answer is no. From the Wall Street Journal:
The Federal Reserve has done enough to spur economic growth and new steps to boost the economy aren’t warranted, Richard Fisher, president of the Federal Reserve Bank of Dallas, said in an interview with The Wall Street Journal.
His comments come amid speculation in financial markets that the Fed might decide to begin a new round of Treasury securities purchases following economic reports that suggest a slowing U.S. economy. “One would be very hard pressed to argue that we need to provide more,” Mr. Fisher said. “The Fed has done its job.” If the economy needs additional stimulus, he added, “it is going to have to come from someplace else.”
True enough, no surprise here. Fisher is known for his efforts to undermine the efforts and credibility of the Fed, fueling the hard money frenzy. More interesting are the thoughts of Federal Reserve Vice Chair Janet Yellen:
The shift toward riskier assets is a normal channel through which monetary policy supports economic activity. But taken too far, this dynamic has the potential to facilitate the emergence of financial imbalances. For example, with interest rates at very low levels for a long period of time, and in an environment of low volatility, investors, banks, and other market participants may become complacent about interest rate risk. Similarly, in such an environment, investors holding assets which entail exposure to greater credit risk may not fully appreciate, or demand proper compensation for, potential losses. Finally, investors may seek to boost returns by employing additional leverage, which can amplify interest rate and credit risk as well as make exposures less transparent….
…The Federal Reserve is fully engaged in monitoring financial markets for potential imbalances and developing the tools necessary to carry out that task. These ongoing efforts include attempting to recognize early signs of misaligned valuations in asset markets and increases in leverage. At present, we see few indications of significant imbalances, and the use of leverage appears to remain well below pre-crisis levels. That said, I've noted some recent developments that warrant close attention, including indications of potentially stretched valuations in certain U.S. financial markets and emerging signs that investors are reaching for yield. Should broader concerns emerge, I believe that supervisory and regulatory tools, including new macroprudential approaches, rather than monetary policy, should serve as the first line of defense.
Two asset bubbles in ten years has definitely made an impression. If Yellen is already seeing the potential for imbalances, would she be willing to throw more gas on the fire with another round of QE2? To be sure, she makes it clear that monetary policy is a last resort to dealing with financial imbalances. But I think that can be inferred as an aversion to tightening policy to address the imbalances; should you ease if you suspect those imbalances are growing? I am still wrapping my mind around this, as I would have expected Yellen to support additional easing.
I also go back to Federal Reserve Chairman Ben Bernanke’s speech in August of last year, in which he raised doubts about the effectiveness of additional quantitative easing:
I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed's balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.
More recently, in his press conference, Bernanke expressed confidence that QE2 had in fact worked. Will the evolution of activity this year cause him to reassess his confidence? Might he conclude that QE2 was not particularly effective? We know he already thought the tradeoffs for additional easing were less favorable than last fall, thus he set the bar high for additional action. If he comes to believe that policy was not effective, that bar obviously only goes higher.
Complicating this story is the possibility the Fed may worry that another round of quantitative easing will only push investors back into the same riskier assets that undermined the recovery. Also from the Wall Street Journal:
The effectiveness of the Federal Reserve‘s controversial policy of buying government bonds to boost the U.S. economy is being hurt by the high oil prices it helped bring about, a former senior official at the U.S. central bank warned Wednesday.
Vincent Reinhart, who headed the Fed’s monetary-affairs department until 2007, is set to tell a House hearing that quantitative easing, or QE, played a role in the rise and volatility in oil prices seen over the past nine months, which differs from the mainstream view at the central bank.
“The Fed gambled that the benefits of the stimulus of QE to financial markets would offset the adverse effects of oil price developments. Whether that gamble pays off is yet to be proven,” Reinhart will tell the Committee on Oversight and Government Reform.
To be sure, the Fed has denied a link. But let’s consider the psychology of the market. Everyone had the same expectations of what would occur if the Fed engaged in additional easing, basically that market participants would largely rally around the inflation play, and thus funnel money into equities, commodities, and foreign currency. Indeed, right now one reason strategists fear abandoning equities is the potential monetary response to current data.
It is likely the case that these flows cannot have a permanent impact on the spot price of key commodities such as oil where storage is difficult and expensive, but even a temporary surge can have disruptive effects in a weak economy. And I think that Felix Salmon made a convincing case that such temporary impacts are real. Moreover, as has been proven, even a temporary surge will raise inflation fears on Constitution Ave. The interplay between market participants, commodities prices, and Fed policy looks quite complicated, fitting with Bernanke’s concern that “one risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.”
So where are we now? Watching and waiting. At this point, there seems to be reluctance on the part of Federal Reserve officials to extend the large scale asset purchases. Putting aside the possibility that the events in Europe turn even more ugly, I don’t think they will seriously consider such a move until 2012 forecasts begin to deteriorate.
For now, watch carefully for Fedspeak that speaks to the forecast – whether or not officials continue to see the current challenges as temporary. And look for concern that additional asset purchases would have no impact, or a reiteration of Bernanke’s concerns that the tradeoffs are less favorable. We are caught between rhetoric and reality - while the Fed may believe no more is coming, the history of this cycle is that more easing has always been needed.