FOMC Action Tomorrow A Preview / Goldman's Jan Hatzius Interview

Jun. 19, 2012 1:07 PM ET1 Comment
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Bret Rosenthal is Principal of RCM, LLC, and founding partner of the Fortune's Favor Family of Funds. Bret Rosenthal is responsible for the day to day management of the Fund’s investment and business activities. Rosenthal Capital Management, LLC, is an independent investment management company founded by managing members Gary and Bret Rosenthal. Prior to starting Rosenthal Capital, Mr. Rosenthal served as Director of Investments at Wachovia Securities, plus Senior Vice President of Investments at Prudential Securities. In both cases, Mr. Rosenthal constructed and monitored investment portfolios for high net worth individuals, trusts, pension plans and foundations. From 2003-2005 Mr. Rosenthal sat on the Directors' Council at Wachovia Securities. Prior to that time, he spent three years on the Chairman’s Council at Prudential Securities. While at Prudential Mr. Rosenthal developed a computerized trading system that was highlighted in the book The Winner’s Circle (2002). During this time, he also became a registered investment advisor and was covered under Prudential’s ADV documents. Mr. Rosenthal received a Bachelors of Science in Business Administration from Boston University. For more on Bret visit:

The favorite guessing game on the circus midway is open for business again and the booth is packed with charlatans, simpletons and everyone in between. The game is titled, "Guess What The FOMC Will Do" or what the locals like to call, "QE or Not QE"

I tend to avoid the Midway as much as possible since the three ring circus offers more than enough entertainment. It certainly feels like a suckers bet and a waste of time to try and guess what a group of people are going to do with monetary policy. As a manager, we must react to what we are given. If we spend too much time building scenarios the ego usually gets in the way of sound judgment when the final answer is bestowed.

I will, however, offer up one ping pong ball towards the glass jar. Earlier this month the European Central Bank (ECB) chose not to change policy for the Eurozone. This decision was greeted with a cacophonous uproar from financial pundits accusing idiocy, stupidity and any other derogatory remark one chooses to insert. The leader of this expert rabble was none other than Jim Cramer who said, "Draghi (ECB Chief) knows nothing."

I responded to the Jim Cramer comment with the following Tweet:

BretRosenthalJun 06, 9:07am via HootSuiteRT @zerohedge: Cramer: "Draghi knows nothing". NOT TRUE, HE KNOWS FED/BOE WILL BE ACTING NEXT SO HE STANDS DOWN. NOT HIS TURN.

Those sentiments continue to be my proverbial ping pong ball. I believe the tell at this table was revealed on June 6th when the head of the ECB chose to stand down. The leaders of the world's central banks are in this together as evidenced by the joint statement and actions on November 30th 2011. Competitive devaluation of currencies through central bank liquidity actions is the tool of choice to combat this global economic crisis. By definition, all currencies can't devalue at the same time so the baton of liquidity creation gets passed from central bank to central bank. The ECB decision immediately led to a rally in the EURO / sell off in the US$. This is the desired effect for the time being to stabilize the EURO as solutions and votes abound in Euroland.

Meanwhile, the Bank of England (BOE) and China have grabbed the baton and are running with it…

BretRosenthalJun 07, 10:32am via HootSuite

China Central Bank cuts benchmark bank deposit rate by 25 bps to 3.25%.THE 1ST OF MANY STIMULUS COMING FROM CHINA. COMMODITIES HEADED HIGHER

BretRosenthalJun 11, 10:21am via HootSuite


…Question is will Ben Bernanke and the Fed choose to join the BOE and China tomorrow and offer new stimulus?

As my ping pong ball soars through the air you may notice I am aiming for the glass jar with a YES written on it….

From Goldman: Courtesy of ZeroHedge

FOMC Preview: QE or Not QE (Hatzius)

We expect the Federal Open Market Committee (OTCPK:FOMC) to ease monetary policy on June 20, in response to the weaker economic data and increased downside risks from the intensifying crisis in Europe.

The form of the easing is a closer call. Our baseline is a new asset purchase program that involves an expansion of the balance sheet, but an extension of Operation Twist and/or a further lengthening of the short-term interest rate guidance in the FOMC statement beyond the current "late 2014" formulation are also possible.

Q: Will the FOMC ease monetary policy?

A: Probably. Although renewed Fed easing by mid-2012 has been our forecast all year, we felt more uncertain about this view a few months ago given the temporarily better data and the apparent shift of the Fed's reaction function in a more hawkish direction. But at this point, we would be quite surprised if we saw no easing this week.

Q: Why?

A: In her June 6 speech, Vice Chair Yellen listed three alternative criteria for further easing:

…[i]f the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective… (emphasis ours).

We believe criterion 1 has been met. As shown in Exhibit 1, we expect the committee to lower its forecast for real GDP growth and raise its forecast for the unemployment rate significantly in the Summary of Economic Projections to be collected at the meeting. If we are right in thinking that the "central tendency" forecast still shows the unemployment rate at 6.9%-7.6% at the end of 2014, many committee members may view this pace of improvement as insufficient, and be inclined to ease accordingly

Exhibit 1: Out Estimates for the Fed's Summary of Economic Projections…

Criterion 2 may also have been met given the deterioration of the European crisis and the tightening of financial conditions of about 30 basis points (bp) since the April FOMC meeting. This tightening is a key reason why our statistical model of FOMC decisions implies that additional easing in June is likely.

Criterion 3 has probably not been met in the committee's view. As shown in Exhibit 1, we expect only the headline inflation forecasts to be revised downward, while the core inflation numbers are likely to be largely unchanged. However, our own view is that there are signs that underlying inflation pressure is actually starting to come off quite sharply, so this criterion may well be met at a subsequent meeting.

In addition, it is important to note that a decision not to ease is tantamount to a tightening. The reason is that the impact of unconventional easing-unlike that of conventional short-term interest rate policy-"decays" over time. This is the implication of our own research, and Figure 9 in Yellen's speech shows that Fed officials have come to the same conclusion. We estimate that this "decay" would push up the 10-year Treasury yield by about 30 basis points (bp) between now and the end of 2013 if no further balance sheet action is taken and the forward guidance is not extended, and Yellen's estimates seem to be similar.

This decay factor kicks in only gradually, so one could argue that it need not be a reason to expect further easing in the near term. However, there are two other reasons besides the decay to believe that the impact of not acting could be sizable even in the near term. First, the market now clearly discounts some probability of easing, so financial conditions would likely tighten if the Fed did nothing. And second, we have found that a small part of the impact of asset purchases on bond yields occurs via the "flow" of Fed purchases than the "stock" of Fed holdings; this implies that very long yields should rise when the purchases stop.

Q: So how will they ease?

A: This is much more uncertain. However, our baseline remains a return to balance sheet expansion, with purchases of mortgage-backed securities (MBS) and Treasuries. There are three reasons why we believe MBS purchases would feature prominently. First, these may be more powerful than Treasury purchases in boosting economic activity on a dollar-for-dollar basis, as MBS yields are not nearly as close to the zero bound as Treasury yields. Second, Fed officials have repeatedly mentioned housing as a key headwind to a stronger recovery, so a policy that directly targets housing would make sense. Third, there may be more support among the public for MBS purchases because of the implied support for US homeowners as opposed to government deficits.
That said, some Treasury purchases would probably be included as well; after all, the stock of Treasuries is rising much more quickly than that of MBS, and Fed officials may therefore want to provide some additional support for this asset class.

Q: How large will the program be?

A: If it is specified as a "stock" of purchases, we would expect a similar size as in past programs, i.e. $400bn-$600bn over 6-9 months. However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month. Although there has been little talk about the latter option, it enables the committee to respond more flexibly to changing economic conditions and may be optically more attractive if the committee is worried about a political backlash domestically or abroad against further balance sheet expansion. Economically, the effects of the two options are likely to be quite similar because financial markets are forward-looking; for example, if markets believe that a purchase flow of $60bn per month will be sustained over 8 months, this would be equivalent to a $480bn stock announcement.

Q: Will the purchases be sterilized?

A: This is a tough call, but on balance we think yes. The argument in favor of expecting sterilization-which involves financing a Fed balance sheet increase via term deposits and/or reverse repurchase agreements as opposed to yet more excess bank reserves-is that the cost-benefit analysis looks quite promising. Economically, we believe the choice whether to finance a balance sheet increase via overnight liabilities (bank reserves) or 1-week/4-week liabilities (reverse repos/term deposits) matters very little. However, there is a belief among some investors and commentators that increases in the monetary base are more inflationary than increases in other types of Fed liabilities; if so, sterilization may be a low-cost way of reducing the risk of a rise in inflation expectations or a political backlash against "printing money."

The substantive argument against sterilization is that it would put upward pressure on interest rates at the very short end of the yield curve (because the Fed would borrow additional funds at a 1-4 week maturity). Moreover, there has been relatively little talk about it since a Wall Street Journal article in March that floated the idea, so it is possible that the idea has fallen out of favor.

Q: Are they also likely to extend the forward guidance from the current "late 2014″ to "mid-2015″?

A: This is not quite our baseline but very possible, especially if the committee decides against renewed balance sheet expansion (see below). After all, such a shift would roughly restore the forward guidance to the same three-year horizon as at the January FOMC meeting, when the "late 2014″ formulation was first adopted. At a minimum, we think that the funds rate forecasts from individual FOMC participants in the SEP are likely to move toward a later exit date (see Exhibits 2).

Exhibit 2: …and the Timing of the First Rate Hike

Q: What if they decide against expanding the balance sheet?

A: The leading alternative to balance sheet expansion is a small extension of Operation Twist, i.e. a sale of the remaining $200 billion or so of Treasury securities with a remaining maturity of 3 years or less, and a corresponding purchase of longer-term Treasuries and/or mortgage-backed securities.

If the committee decides to confine itself to an extension of Operation Twist, this would further increase the probability of a lengthening of the forward guidance from the current "late 2014″ formulation to "mid-2015″ in order to reduce the risk of doing too little and also to mitigate any upward pressure on short-term rates that might otherwise result from selling yet more short-term Treasuries.

Even so, we believe that an extension of Operation Twist could well be insufficient on its own and could thus be followed by additional easing action before long. Recall from the discussion above that the "decay" of unconventional policy could boost 10-year yields by 30 basis points over the next 18 months. Using standard estimates, a further $200bn twist combined with a lengthening of the guidance would offset only about half of this impact. More than this is likely to be needed eventually.

Q: Could the committee make an extension of Operation Twist more powerful by selling intermediate-maturity Treasuries (e.g. 4-years)?

A: In principle yes, but we do not find strategy very attractive. The main reason is the risk of putting upward pressure on intermediate yields and thereby sending very mixed signals about monetary policy. If the committee wants to do significantly more than implied by a further $200bn twist alone, balance sheet expansion is likely to be needed.

Q: Do you expect a cut in the interest rate on excess reserves (IOER)?

A: No. We believe that the committee views the forward guidance as a better way of mitigating upward pressure on short-term rates than a cut in the IOER because it seems less likely to interfere with money market functioning.

Q: Do you expect additional Fed easing to be effective?

A: Only moderately. While we believe that a sufficiently large program focused on the mortgage market would help, it is unlikely to be very powerful. That doesn't mean Fed officials shouldn't do it, since we view the costs of additional easing as low. The risk of inflation is remote, and even when it becomes less remote Fed officials should be easily able to tighten policy sufficiently.

But it does mean that it makes sense to think about other forms of policy easing. Obvious candidates would be fiscal policy or purchases of non-government guaranteed assets, but these require the cooperation of Congress and are therefore probably not feasible. Instead, a move in the direction of "unconventional unconventional" options holds more promise. These include the Evans proposal of promising not to raise rates until the unemployment rate has fallen to a specific level and a nominal GDP level target. We do not expect these to be adopted in the short term, but they could be more effective than balance sheet action and date-based forward guidance on their own. They may therefore represent the next frontier for Fed policy should the recovery continue to disappoint.

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