By Rom Badilla, CFA
The Federal Open Market Committee is set to meet Tuesday. Results should be announced on Wednesday to determine the outlook for the U.S. economy, which in turn sets the direction of monetary policy. After last week's tape bomb by European Central Bank President, Mario Draghi where the euro will be defended at all costs, coupled with Ben Bernanke's testimony in mid-July that they are "prepared to act", the stakes are high for the Fed to follow suit.
There is talk around both the media and investment circles that the Federal Reserve will announce another round of Quantitative Easing where the Fed expands its balance sheet. While recent economic data has been lackluster and the conditions across the pond in Europe are severely strained, it might be premature to talk about Quantitative Easing due to current levels of inflation expectations.
When we look at inflation expectations which is the yield differential between 10-Year U.S. Treasuries and 10-Year U.S. Treasury Inflation Protected Securities aka TIPS, and overlay it with prior balance sheet expansions, we can see the conditions necessary for another round of QE.
As you can see from the chart above, inflation expectations (red line) have dipped below the 2% threshold (green shaded area) prior to the initial announcement of QE and subsequent period of Treasury purchases (shaded in grey).
Prior to Round 1, which was announced on November 25, 2008, the yield differential fell below zero briefly and was at 0.20% or just 20 basis points the day before the announcement. While Round 1 was completed by the end of March 2010, the U.S. central bank went to the well once more.
The Fed initiated Round 2 on November 3, 2010, but Bernanke provided the markets strong hints of the Fed's intentions in his Jackson Hole speech on August 27. The Fed kicked off Round 2 on the grounds of promoting a stronger pace of economic growth and "to ensure that inflation, over time, is at levels consistent with its mandate." As was the case before in Round 1, the yield differential fell to a low of 1.51% just days prior to the announcement.
Given the Federal Reserve's dual mandate of price stability and full employment, we can understand the logic of the process. This analysis shows that the Federal Reserve needs to see evidence of the former before it can act to address the latter mandate. Prior to the Fed setting inflation targets earlier this year, price stability has historically fallen somewhere in the 2-3% range.
In the case of the first two rounds and in light of signs of contracting economic activity, the country was facing significant deflationary pressures where inflation expectations were falling significantly below that range. At that point, Bernanke and Company had the green light to act. The Federal Reserve added fixed income assets to its balance sheet and flooded the system with liquidity in order to reflate the economy.
Currently, inflation expectations are above the same threshold. The yield differential between the two market indicators is at 2.08% with a recent low of 2.00% set on July 25, 2012. Granted, the spread has been declining from the 2.30-2.40% range set in March and April 2012. However, the fact remains that it is still elevated by my eyes and beyond the Fed's liking for another round of QE. That is, asset purchases are highly unlikely for the August FOMC meeting (I could see changes in guidance where low rates will be in place until 2015). Looking farther out though, QE might be in store if current conditions continue to deteriorate.
While the millions that are currently unemployed will agree, economic conditions are far from perfect. Employment growth has yet to gain much momentum in this recovery as the unemployment rate remains sticky at 8.2%. Nonfarm Payrolls figures have not picked up as hoped and Initial Jobless Claims continue to hover in the 350,000 to 400,000 range which is closer to levels associated with job destruction than creation.
Furthermore, the fiscal cliff and the European Debt crisis is another hurdle of economic uncertainty that can weigh on consumers and businesses and which could pressure downward pressure on the economy.
Given these escalating headwinds, coupled with the latest ISM Business Survey, it's easy to see that the Fed may act in another round. However, action in the form of QE is not in the offing for the August 1 announcement which could disappoint the market, in particular buyers of risk assets.
Disclaimer: The above content is provided for educational and informational purposes only, does not constitute a recommendation to enter in any securities transactions or to engage in any of the investment strategies presented in such content, and does not represent the opinions of Bondsquawk or its employees.