Since the beginning of the recent economic crisis, the Federal Reserve has pegged the Fed Funds rate at 0-25 bps and engaged in two rounds of quantitative easing followed by an operation twist (officially called the Federal Reserve's maturity extension program). Surely there has been dissension within the Federal Open Market Committee (FOMC) about doing quantitative easing (QE) or operation twist (OT) and there has been a fair amount of criticism in the media and the investment community about the ill-effects of monetary easing, including the risk of rampant inflation. The official statements from the past two FOMC meetings in March and April have led the markets to believe that another round of either QE or OT will likely not happen. However, stepping back and taking a broad look at the U.S. economy right now, I believe that another round of operation twist may be on the cards in the fall of 2012.
First let us examine all the reasons why the market thinks another round of QE or OT is unlikely. Most of it has got to do with improving economic conditions in the U.S. Following are some of the major economic indicators that have shown a significant uptick in recent months:
a. Non-farm Payroll: the month to month change is non-farm payroll numbers have been positive and well over 200,000 through most of 2012, thus marking a clear uptrend.
b. Weekly initial jobless claims filed: Starting October of 2011, this number has consistently been below 400,000 and the number has moved from 397,000 for week of October 22, 2011 to 370,000 for the week of May 12, 2012, and consistent downward trend.
c. New homes sales have finally picked up and point to a recovery in housing. Sales over the past three months have averaged 344,000 units, which is a 14% increase over the same period last year. Existing homes sales also rose by 3.4% in April and the median home price jumped up by the most in six months.
d. The S&P 500 Index rallied over 20% from its lows in October of 2011 which is when economic data started to trend upwards. While there has been a recent correction, we are still net up by about 17%.
e. Consumer Confidence: The University of Michigan consumer sentiment index, a gauge of consumer sentiment in the US, reached its highest level in four years and now stands at 77.8. Being a leading economic indicator, this bodes well for U.S. economic outlook for the coming months.
So one can look at the above indicators and feel pretty good about the US economy. Then why would the Fed ever consider more QE or OT? Well, one needs to focus on the bottom line! The Fed has a very specific dual mandate, and that mandate does not consist of maximizing consumer sentiment, or home sales, or the S&P500 (SPY) Index for that matter. The dual mandate consists of (i) anchoring long-term inflation expectations to about 2%, and (ii) promoting maximum sustainable employment.
The long-term sustainable unemployment rate in the U.S. is considered to be between 5%-6%, about 30% lower than the current rate of 8.1%. Hence, the Fed needs to work relentlessly to continue to foster conditions to push down the unemployment rate. The Fed also understands that though the official unemployment rate is 8.1%, this number is lower than the "real" unemployment rate because a large number of people have in fact given up looking for work and thus do not get counted towards being "unemployed". As the economy recovers they will likely start looking for work again and thus start to get counted as unemployed before they actually get a job, creating headwind for the unemployment rate to come down. Statements from the Federal Reserve itself claim they even by 2014, the unemployment rate would be in the range of 6.7%-7.4%, significantly above the long-term sustainable trend. What does this mean? This means that the Fed will continue to engage in unconventional monetary policy to improve economic conditions and spur job growth.
To further support this point let us look at the Gold Standard used by the Fed and leading central banks around the world to guide monetary policy - the Taylor Rule. First suggested by Dr. John Taylor in 1993, this rule has been customized by the Fed as a guide for monetary policy to set the Fed Funds rate. As per a recent article by the Cleveland Fed, the Taylor rule suggests that the Fed Funds rate should currently be negative and projects that it will likely remain negative through the second quarter of 2014. However, because the Fed is stuck with the zero bound, it cannot make the rate negative and hence has to engage in "unconventional" monetary policy like quantitative easing or operation twist to do the extra work. Hence, I expect the Fed to regularly engage in unconventional monetary policy through 2014. The 2014 projection in the paper also explains Fed Chairman Ben Bernanke's repeated announcements about keeping rates low through 2014.
A lesser but nonetheless significant reason why the Fed would do another QE or OT is because Washington has been utterly impotent providing any meaningful support to the economy. Come December, the Bush-era tax cuts are set to expire and several fiscal cuts are supposed to come into effect as well, thanks to the failure of the super committee last year. Notwithstanding what the outcome is, there will be significant political debate about extending the tax cuts and fiscal contraction. This uncertainty will start to get to the markets come fall season. Thus, a QE or OT will be a good antidote to counter market nervousness regarding the imminent fiscal contraction. In my opinion a fiscal contraction will be a grave mistake and one only needs to look back to 1937 to realize how a fiscal contraction had slid the US into a double dip recession.
So now that we have enough reasons to support further QE or OT, let us consider which of those two it is most likely to be. My money is on OT, simply because unlike QE, OT does not flood the economy with any new money and hence does not aggravate an inflationary threat the way a QE does. Given that current inflation expectations are hovering slightly over 2%, the Fed would not want to hurt its credibility as an inflation hawk by outright printing more money. Commendably, Bernanke has recently made statements to this effect. Operation twist would simply involve selling treasuries of a shorter duration and using that cash to buy treasuries of a longer duration, thus keeping the money supply in the economy constant.
Get ready to twist!