For the past month, markets have been obsessed with what, if any, actions Ben Bernanke and Co. will take to stimulate the economy. Especially after the Republicans essentially ruled fiscal stimulus dead, the market is desperate for some sort of monetary stimulus, even if it is only effective in psychology rather than function. The most sought-after Fed action would be a renewed round of quantitative easing, or QE3. While this is a possibility that the Fed has discussed in their recent statements on the economy, we believe that the likelihood of this particular policy option is actually extremely low, with other options being much more favored.
The last two texts released by the Fed shed light into which way Bernanke may be leaning: Bernanke’s Jackson Hole speech, as well as the Fed minutes from the August 9th meeting.
When considering the August 9th minutes, context from the prevailing situation is very useful to keep in mind. The US debt rating had just been downgraded by S&P, causing a 7% selloff in the major equity indices the day before. Markets were falling apart, and the fall of 2008 seemed to be back in full swing. August’s Fed meeting happened to be scheduled for the day after the huge stock market rout, and investors had high hopes that Bernanke would come to the rescue, pumping another enormous amount of liquidity into the system or a similarly drastic action.
From the backdrop of this dire situation in risk markets, policy makers had to come up with a response. From the August Fed minutes, we can see that a range of policy responses was discussed, from a renewed round of quantitative easing, a “twist” operation, setting explicit inflation and/or employment targets to doing nothing at all. While the minutes are somewhat ambiguous, it appears that two FOMC members favored the nuclear response of more quantitative easing and renewed monetary expansion immediately.
However, the three dissenters from Bernanke’s eventual decision dissented because they believed no change in the language of the Fed’s statement was warranted. These three FOMC members are inflation hawks, and prefer waiting to see whether economic fundamentals improve on their own or if further stimulus is warranted.
It is interesting to note that all FOMC members indicated that the monetary policy response was not sufficient to address the employment problems, and a few of the members indicated that they believed monetary stimulus would have no effect on improving economic fundamentals.
Furthermore, the FOMC members stated that inflation expectations had picked up and remained stable since QE2 began. The Fed minutes revealed a sharply divided Fed, but Bernanke’s final decision is interesting when considered in the light of the sharply contrasting views of his peers.
Bernanke’s essentially minimalist choice of adding a date target to the Fed’s low interest rate pledge reveals that he prefers the least amount of intervention possible. While markets were absolutely falling apart, Bernanke still opted for what amounted to a verbal intervention in the market.
To his delight, it had quite a good effect, as that day marked the current low for the S&P 500 so far this year. Bernanke is a very smart man, and he realizes that quantitative easing and other radical policy measures have diminishing levels of success each time they are employed. Along those lines, he will only employ the most drastic of these tools, quantitative easing if he has no other choice and he has sufficient economic justification to back him up.
While most critics point to QE2 as an absolute failure, they are wrong on this point. QE2 was successful in increasing inflation expectations, at a time when the threat of deflation was beginning to rear its head again. While it also had the unintended effect of commodity hoarding, crude and other commodities’ recent fall indicates that these effects truly may have been transitory and the result of speculation, not true demand.
When considering the possibility of QE3, the economy and sociopolitical climate is in a much different state than it was a year ago. Inflation expectations, as Bernanke has mentioned numerous times, are now stable and positive, whereas they showed signs of decreasing last year. Furthermore, we are coming into a Presidential election year in which the number 1 issue is the economy. We have already seen pundits such as Mitt Romney proclaim that Bernanke is a “traitor” for his implementation of easy monetary policy. With the political stakes this high, Bernanke is even more afraid to implement aggressive policy changes if he does not absolutely have to.
Also, in the Jackson Hole speech, Bernanke glossed over possible Fed responses to further economic deterioration, instead spending the bulk of the speech on imploring government officials to take the proper fiscal steps necessary for economic growth, as well as emphasizing the Fed’s role in promoting stable, low inflation.
Specifically, Bernanke indicated only that the Fed has “a range of tools that could be used to promote additional monetary stimulus,” spending no time elaborating on what those tools might be or if they might be employed. Bernanke repeatedly called out policymakers, stating that the US might be “well served by a better process for making fiscal decisions,” indicating that he believes much of the recent malaise is a fiscal issue rather than liquidity problem.
Finally, and most importantly, Bernanke indicated that the Fed’s most important economic role was to provide “monetary policy that ensures that inflation remains low and stable” and that “most of the economic policies that support robust economic growth are outside the province of the central bank.”
Bernanke has mentioned numerous times that the potential benefits of any monetary policy need to be accompanied by a consideration of the potential inflation risks. He has also repeatedly stated that he sees the current outlook for inflation as being where he wants it to be, indicating his bias against pumping more liquidity into the system and further stoking inflationary pressures. While the market has taken every dovish statement and action and amplified it to the extreme, we believe Bernanke is much skewed to the neutral side of the policy spectrum, and that there is very little chance of aggressive policy action.
In summation, we believe that Bernanke’s statements indicate that he sides with the hawkish elements of the FOMC, although his preferred course of action is the status quo. He will only be moved to the extreme policy action of QE3 by a truly extraordinary event: either a significant worsening of economic data, or a sudden, renewed plunge in risk asset markets.
At this time, we do not believe the situation to be nearly dire enough for him to be forced into QE3. In fact, even if he decides to initiate more monetary policy, he will almost assuredly initiate a twist operation rather than an outright QE3; in the Fed minutes, the twist operation was discussed in more detail, and it was emphasized that such an action would not increase the size of the Fed’s balance sheet.
In our analysis of gold prices, we will explain why the size of the Fed’s balance sheet is important, and why current market sentiment on precious metals has shifted to an illogical extreme.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.