'No QE' Bernanke Will Disappoint Markets Friday

Includes: GLD, IVV, SPY
by: John Early

Further stimulus from the Fed is highly unlikely in the next few months. So "risk on" markets should be disappointed on August 31 when Ben Bernanke makes his speech in Jackson Hole. The stock market (NYSEARCA:SPY), (NYSEARCA:IVV) and gold (NYSEARCA:GLD) will likely decline. The dollar and bond prices could get a boost.

There are three reasons the Fed will not act. First of all, "Operation Twist" is still going on. Furthermore, the monetary and inflation conditions that have prompted quantitative easing in the past do not currently exist. Finally, more easing at this point has a bigger downside risk for the future than the potential near-term benefit can justify.

Operation Twist, where the Fed sells short-term Treasuries and buys longer-term Treasuries, has been extended through the end of 2012. So the Fed is still in an easing program. In Bernanke's August 22 letter answering Darrell Issa's question of whether additional quantitative easing was premature he states,

Of course, the extension of the maturity extension program - announced at the conclusion of the FOMC's June meeting - is still in the very early phases of having its effect on the economy.

This is only part of a more hedged answer to Issa's 5th question. The full letter is here. Previous Fed easing programs did not overlap. In fact there were multi month periods between QE1, QE2 and Operation Twist. Unless the Fed forecasts significant deterioration in the economy, Operation Twist will conclude in December followed by a multi-month period to see the lagged effect. For all the Fed knows, the current easing policy is as much stimulus for the economy as is now prudent.

Before discussing how monetary and inflation conditions do not warrant more QE or how the potential benefit of QE does not justify the potential harm, it is helpful to show the context of how inflation influences growth and how the money supply as measured by M2 influences inflation.

The last 90 years of data suggest the growth optimizing inflation rate is about 1.2% and that deflation is several times more destructive to growth than inflation. If other influences on growth are neutral, an inflation rate between about 0.4% and 3% would typically correspond with above average growth. The monetary policy that best serves creating growth and low unemployment is one that keeps inflation in this optimal range.

inflation v growth

Since deflation is so destructive, central banks around the world usually have an inflation target higher than the 1.2% the chart suggests is optimal. Currently the Fed is targeting an inflation rate of 2%. Since the inflation rate often drops 2% after the start of a recession, it is easier to keep deflation from occurring if the inflation rate going into a recession is at least 2%. If deflation occurs during a recession, the risk of a prolonged downward spiral increases.

If you want to know how price changes affect consumers, the headline rate of inflation is the one to look at. On the other hand, if the Fed wants to respond to the underlying trend in inflation rather than react to volatile commodities markets, following the core rate which excludes food and energy gives a more reliable perspective. Over long periods the change in these two price indexes are virtually the same, as shown in the chart below. The year over year rate of headline inflation is much more volatile though: In the last 10 years the headline rate has ranged from -2.0% to 5.5% while the core rate has only ranged from 0.6% to 2.9%. The Fed has a great deal of influence on the long-term rate of inflation, but virtually no control over short-term fluctuations in commodities prices.

core v headline

The most significant influence on the rate of inflation is the rate of money growth. The measure of money called M2 appears to have the strongest correlation with inflation. I have found that the growth rate of M2 over a two year period has a strong correlation with year over year rate of inflation 32 months later. The correlation is shown below as both a scatter plot and a time series.

inflation v m2

Each point on the scatter plot represents a two year growth rate of M2 and what the inflation rate was 32 months later. The red curvilinear fit through the scatter plot suggests that money growth below 8% has a more modest effect on inflation, while money growth above 8% has a bigger effect on inflation. Other influences being neutral, an 8% growth rate in M2 implies a 4% inflation rate 32 months later.

Unlike conditions leading to QE1 and QE2, neither Inflation nor money growth are running at a level where deflation would be a concern. When QE1 launched in November 2008, the CPI had fallen 1% in the previous three months or at an annualized deflation rate of 3.8%. The year over year growth in M2 had recently been at 5.4% near the low end of the desired growth rate. However, the core rate of inflation was near the desired level of 2% a year.

QE2 was hinted at in Bernanke's August 2010 speech at Jackson Hole and began in November. The core rate of inflation was 1% at the time of the speech and hit a low of 0.6% as QE2 began. Growth in M2 was down to 1.6%. The headline inflation rate was around 2%.

Current rates of M2 growth and inflation do not warrant QE3. In the last year M2 has grown at 8% which is above the optimal range and risks significant inflation in the future. The core rate of inflation at 2.2% is slightly above the Fed's target. While headline inflation has gotten down to 1.4%, recent price spikes in oil and agricultural commodities appear ready to send it higher.

As long as the headline rate of inflation does not turn to deflation, the core rate of inflation stays above 1% and the growth of M2 stays above 4%, quantitative easing is highly unlikely. If we get close to crossing below one of these thresholds, QE is back on the table.

The risk of QE3 outweighs the potential gain. If we were on the cusp of deflation, the Fed would pull out all the stops to prevent it. In the last 3 years, the Fed has taken extraordinary measures to prevent deflation and keep the money supply growing at a pace consistent with robust growth and inflation in the range most favorable to growth. These extraordinary measures have tripled the monetary base, which is sometimes called high powered money. The monetary base is not money in the sense that it is not available in the hands of the public to spend and potentially drive up prices. However, it is in the hands of banks and creates the potential for massive lending and the fastest growth in the money supply this country has ever seen.

All of Bernanke's statements about accommodative monetary policy come in the context of the Fed's dual mandate of stable prices with low unemployment and keeping inflation in the range most conducive to growth. I understand this to mean keeping inflation in the range of 0.4% to 3%. Recent money growth risks violating the upper end of the range. The 8% growth rate in M2 over the last 2 years implies 4% inflation 32 months from now. Last month, M2 grew at a 9% rate. If money growth continues in the next few months at this above average trend, the Fed may need to take its foot off the gas. If money growth accelerates, it may need to tap the break.

QE is highly unlikely, given there is an ongoing stimulus program and that this program or past simulative efforts have pushed money growth to a level that threatens unacceptably high inflation and that the current level of core inflation is above the Fed's target.

The Fed's mandate is for stable prices with low unemployment. Pursuing this goal in the last three years has corresponded with higher stock prices. Pursuing its mandate in the next year could easily mean lower stock prices.

Disclosure: I am short SPY, IVV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: There is no guarantee analysis of historical data and trends enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.

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