Almost immediately after I published Forex Markets Indicate QE Unlikely, the forex market shifted toward a weaker dollar, indicating higher odds of QE. Nevertheless, I still don't see broad-based Large Scale Asset Purchases (LSAP) coming from the Fed tomorrow.
Analysts across the spectrum have jumped on Friday's jobs numbers as a sign that the Fed must be on the verge of QE3, but they seem to have wholesale tossed out every other indicator, including Thursday's jobs numbers. Obviously, the BLS data is more official than the ADP data, but that doesn't mean the jobs picture is quite as clear as doves might hope.
Aside from the employment data, it is worth examining the Fed's other mandate, price stability. The July CPI data indicates overall inflation is hovering around 1.4% and core inflation over 2%. Moreover, overall inflation will likely rise due to the drought, causing an increase in food costs, which will push headline inflation higher. This means that the U.S. economy is in no threat of deflation, and any move to broadly devalue the dollar could cause problems in the consumer sectors of the economy.
Doves will point to the international markets and correctly identify that growth in Asia is slowing and that is dragging down global growth. While this is accurate, it is not something that the Fed can directly impact with QE. Perhaps more importantly, with the ECB announcing a bond buying plan and the German court supporting the ESM, Europe seems to be stabilizing. This is not to say that European plan is any sort of bull market guarantee, just that the global pressure for Fed action is mixed.
Perhaps most important from an investor standpoint, the S&P is at its highest point since the start of 2008. While the Fed may not expressly make decisions to influence equity markets, they certainly don't have any interest in inflating a bubble if it can be avoided.
The Fed's Playbook
In all of the clamoring for another round of QE, most analysts have failed to clarify what counts as QE versus some other stimulative policy. Moreover, many forecasters seem to be forgetting that any action would be targeted at stimulating job growth, not equity markets. So, what are FOMC members considering in their meeting?
- As many analysts have pointed out, the FOMC is considering further asset purchases. However, these purchases would likely be targeted in the Mortgage Backed Securities market, and it is unlikely that the Fed wants to explicitly pick a market winner by only backing one asset class.
- The FOMC is considering extending forward guidance into 2015. Any extension into 2015 would be a hollow move since Bernanke's term is up in January of 2014, and a potential Romney Presidency means that he would be replaced with someone who would likely alter the guidance immediately.
- The FOMC is considering altering the guidance to comply with a set of agreed upon economic conditions. This would satisfy hawks and solidify the guidance under different Fed leadership, but Bernanke has expressed displeasure with this more opaque type of guidance communication.
- The FOMC is considering stimulating lending by decreasing the rate the Fed pays banks on excess reserves. Bernanke has previously expressed reservations about this policy, but it is the simplest way to increase the velocity of money in the system and force businesses to begin utilizing the trillions in cash reserves they are currently hoarding.
- The FOMC is considering stimulating lending with a plan similar to the British "Funding for Lending" scheme. Bernanke and the FOMC minutes have indicated that they have been watching this plan closely for some time. The only trouble is that any such policy would likely involve the Treasury and with political uncertainty due to the November election, the Fed may not want to initiate a joint program that could be altered in a new administration. Conversely, the threat of a new administration may also nudge the Fed into action on this policy right away in order to establish the program before a potential change in leadership.
- The FOMC is considering doing nothing new. They might just wait and see how the market fares through the rest of 2012.
In some sense, the first five options are all stimulative, but it is unclear what some analysts mean when they say QE3. The Fed does not use the term QE, and the commonly mentioned QE2 was what the Fed calls "Large Scale Asset Purchases," so by that definition, most analysts seem to be saying that they expect only option 1 to be announced tomorrow. I am less convinced. I think all six of these options are possible, and it is misleading to create the dichotomous choice between QE and no QE. Any Fed policy will likely be more nuanced than such commentary acknowledges.
All six of the options above have potential market implications. The first option would stimulate the real estate market and help bolster the markets for collateralized debt, while the second and third options would put further downward pressure on interest rates. Options four and five would have a more mixed impact, potentially weakening financials while also jump-starting the collateralized debt markets and putting downward pressure on interest rates. Option six would strengthen the dollar, but likely drive equity markets lower. Any announcement of option six would likely be accompanied with a statement indicating the Fed might act with stimulus in the near future, so that may limit gains to the dollar and mitigate losses in equities. Ultimately, the most important point is that all of these options are possible, and investors should be wary of any analysis that presents the Fed's policy choices as simply QE or no QE.