The Wall Street Journal and The New York Times both posted articles on July 24 declaring that the Federal Reserve is set to act at next week's FOMC meeting. In particular, these articles focused on one sentence by Chairman Bernanke in his Congressional testimony last week. They contend that Bernanke's statement that "we (the Fed) are very committed to ensuring, or at least doing all we can to ensure, that we continue to make progress on unemployment," is a sign of QE3 on the horizon. This interpretation is simplistic and inaccurate.
It is simplistic because these articles, like most sources in the media, act as though Ben Bernanke is the holy dictator of the Federal Reserve. While the Chairman is powerful, he is powerful as a consensus builder, not a dictatorial leader issuing edicts about his policy preferences. As Bernanke himself has repeatedly said, they have 19 decision-makers in the room and 12 of them vote at any given meeting. So, it stands to reason that this means we should be looking at what other Fed officials have been saying lately, not just the Chairman.
As I said in my analysis of the speech given by Fed Governor Elizabeth Duke last week, signs are not pointing to QE3. Which brings me to my second point, by looking only at the tight-lipped Chairman, rather than the whole group of decision-makers, the media narrative ends up being flat wrong. Perhaps they are just trying to grab headlines by talking about a quantitative easing policy that is now broadly understood, but it is horribly misleading and it almost certainly contributes to market volatility in the run up to FOMC meetings.
So, if QE3 is not on the horizon, what is?
No question about it, the data is not pretty. Growth is slowing globally with China, India and Brazil all growing at a slower pace than almost any point in the last decade and Europe potentially entering a recession. Manufacturing in the U.S. is still struggling and although the long term outlook for U.S. real estate is positive, in the short and medium term the numbers are still fluctuating. Perhaps most disconcerting for Americans, employment gains have slowed and inflationary pressure abated indicating weak consumer demand. Given this data, it is not unreasonable to assume the Fed might act, but it is the simplicity of assumption that the action would be QE3 that is so egregiously inaccurate.
The Fed has four realistic options in responding to the recent data:
- The FOMC can do nothing. They can take a wait and see approach that banks on the fact that it was just 6 weeks ago that they decided to continue Twist. Obviously the markets will not like this and it may box the Fed in to not acting before the November election for fear of political backlash (after next week they only have two more meetings before the election).
- They can initiate some new transparency policy. This has been a favored method by the Fed to placate markets by doing something without having to alter monetary policy. Markets will probably not respond favorably to this either, but any drop will likely be muted because investors will at least take this minimal action as a sign that the Fed is making policy changes, even if they are not the changes that investors want.
- As I suggested in my analysis of the June FOMC minutes, the Fed has been eyeing the British "Funding for Lending" program for some time and in his June press conference Bernanke even admitted that the Committee was "very interested in it." The goal of this program is to boost bank lending to non-financial businesses and households by lowering the cost of funding for banks that engage in that lending. The program also provides incentives for banks to increase their lending. This serves to increase liquidity and access to credit by those that need it. In essence, the Fed would be providing long term loans to banks specifically to spark mortgage lending and reinitiate the securitization process in order to move mortgage securities back into the food chain (with some oversight, presumably). While legal details of an American version of this program are unclear, it is feasible to implement this without growing the Fed balance sheet thus making it politically less dangerous than QE3. The trouble is, without any prior media attention, it will take investors a long time to figure out what implications this has for the market, so you would likely see confusion in the markets, rather than a discernible bounce or drop after the announcement.
- Although I view it as an outside chance, it is possible that the Fed will move ahead with a simple reduction of the interest rate the Fed pays to banks on their excess reserves. Like the Funding for Lending program, this would also incentivize banks to lend money since sitting on it will cost them more. However, in the past Chairman Bernanke has expressed concerns that a simple rate reduction could damage the functioning of short-term money markets. This plan is definitely simpler than the one outlined above, but the downside risk is greater meaning that markets will likely initially like the idea of some simple stimulus, but then be restrained by fears over unforeseen consequences.
While I view all four of these options as possible, and we may see signs over the next few days that will favor one policy over the others, the big take-away here is that QE3 is not coming and investors need to prepare for that fact.
Due to everyone's familiarity with it, QE3 would create a jump in equities across the board, but these options will not elicit such a universal market response. The first two options will almost certainly send equity markets downward, with the drop being more severe if the FOMC elects to do nothing than if they elect to begin some new communication measure. The third and fourth options outlined here are stimulus, but will not elicit the same response as QE3. If option 3 continues to elude media coverage, markets will have a muted response while investors try to understand the program and then we should see a jump in equities prices (particularly financials, homebuilders and durable goods producers) toward the end of the trading day. The response to option 4 will be more mixed, with similar initial confusion followed by a likely decline of financials, but a rise in other sectors of the market.