2 Sep 2011


August appears like it may be a pivotal turning point in economic trends after a slew of economic data released draws a picture of an economy in peril. Consumer confidence numbers disappointed this morning, housing, employment and inflation are all looking poor, yet the ultimate question is how will the Federal Reserve react. Let’s see what we learned from the Fed this month:
The month of August kicked off with the Federal Reserve debating how to deal with a weakening stock market and disappointing economic results. This lead to the Fed’s monthly policy release stating that they would commit to keeping interest rates between 0-0.25% until at least mid-2013. This replaced the former language which just stated the Fed would keep interests rates low for ‘an extended period’. There were three dissents among Federal Open Market Committee members, the most dissents in almost 20 years, as doubts over the Fed tying their hands to a loose policy disturbed the more hawkish Fed members.
The meeting’s minutes were released yesterday and gave us a deeper insight into the decision, most important being the committee’s commitment was meant to be conditional. From the minutes,
“Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee’s flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
The Fed also indicated more easing can be expected if growth disappoints and, in a traditional ‘setting oneself up for failure’, the Fed’s expectations for GDP are unrealistically high:
Short-term growth is likely to disappoint with housing remaining in a rut, inflation being high, fiscal balances are tapped out, and given the lack of capital inflow to the US after this month’s disappointing TIC data, the Fed is almost certainly going to step in.
Many have speculated that easing will be seen in the form of a long-rate-biased maturity shift in the composition of the Fed’s balance sheet, also known as “operation twist”. Since the Fed has already secured short-rates by committing to keep the overnight rate at its historical low, “operation twist” would lower long rates without growing the Fed’s balance sheet, by effectively swapping short-maturity assets for long ones. The Fed has already biased their purchases towards the long-end of the yield curve, when they went on a mass scale purchase of mortgage-backed securities followed by mid to long term treasury bond purchases. Because of the Fed’s current heavy weighting to long-maturing assets, the fact long rates are already very low, and funding shortages could still develop, some Fed members have argued that this type of program would not be very effective.
A different option which seems to have more support in the Fed is another quantitative easing program, in contrast to the qualitative loosening just mentioned, commonly dubbed ‘QE3′. This would involve a strong outright expansion of the Fed’s assets after being purchased with printed money. The main point of significance, should more easing occur just because of faltering growth, is markets will interpret the signal as the Fed having lost any care for controlling their inflation appetite. The current inflation rate is already almost twice as much as the Fed’s 2% target:
Even the Fed’s preferred inflation gauge, the PCE deflator, just had its annual reading as of July recorded at 2.8% – well above the Fed’s target. The only measure the Fed can rely on to keep up the nonsense they preach about inflation expectations being stable, is the TIPS spread. However, as we discussed here, the TIPS spread is not a market sentiment indicator since the Fed is the biggest player in the Treasury market, thereby shaping and distorting those expectations.
Fed Chairman Ben Bernanke has signaled in the past that deflation would need to be present before he could justify another QE program. Currently the economy is operating at relatively low rate of capacity utilization, though its on the rise back up, yet inflation, as already mentioned, is very high and so is unemployment. This should put a nail in Bernanke’s theoretical models, but even he cannot stay consistent if he turns to growth as the impetus for another balance sheet expansion. Gold can be expected to perform very well on news that the Fed is formally and publicly furthering the use of the printing presses to defend growth without concern for inflation.
Other easing options which the Fed has mentioned include committing not only to keeping interest rates low, but also securing the size of their balance sheet by commitment. The Fed has already communicated this fact well despite doing so in less formal settings, so the impact of announcing a formal commitment is likely to be negligible.
A last popular move which could be implemented is a lowering of the target range from 0-0.25% down to 0%. Effectively this would amount to about an eighth of a point cut in the effective federal funds rate – not much more support to borrowers. This would help the Fed however, as the interest they pay is an expense, and this decrease in their cost of funding would bolster their balance sheet’s status. Even small changes in the rate the Fed pays on excess reserve balances is significant, as the size of these reserves is at a record high:
Interestingly, even though this policy would make it cheaper for banks to borrow, the size of the Fed’s balance sheet would not grow as much as otherwise, implying a relative tightening, and banks would lose the income generated on their reserves

We're Going Into a Recession

Nouriel Roubini spoke to Bloomberg TV's Margaret Brennan today, giving his latest forecast for the U.S. economy, the European debt crisis and economic challenges in China.
Roubini told Bloomberg TV, "we're going into a recession based on my numbers" and that "we are running out of policy tools" as the U.S. and European governments no longer have the resources to bail out their troubled banks.

Roubini on what the Fed could do at this point to avoid a recession:
"We've reached a stall speed in the economy, not just in the U.S., but in the euro zone and the UK. We see probably a 60% probability of recession next year and unfortunately we're running out of policy tools. Every country is doing fiscal austerity and there will be a fiscal drag. The ability to backstop the banks is now impossible because of political constraints and sovereigns cannot bail out their own distressed banks because they are distressed themselves."
"Everyone would like a weaker currency, but if the currency's weaker, another has to be stronger. There'll be more monetary easing and quantitative easing done by the Fed and other central banks, but the credit channel is broken. The velocity has collapsed and all the extra money is going into reserves. There was asset deflation, but it occurred because the economic numbers in August started to improve even before QE was done. This time around the macro data is negative, so yes, the market is rallying on the expectation of QE3, but I think it will be a short-lived rally. The macro data, ISM, employment, and housing numbers will come out worse and worse, the market will start to correct again. We're going to a recession, we are at stall speed and we are running out of policy bullets."
On whether there are any monetary policy tools that might be more helpful than others:
"The ones that are being discussed by the FOMC will not have much of an effect because if you lengthen the maturities, you are buying long-term Treasuries and selling short-term, you are flattening the yield curve in a way that hurts the banks...This time around we will not have an additional purchase of Treasuries or fiscal stimulus. We will have a fiscal drag and the short-term effect of a rally in the market will fizzle out when the real economy is going in the tank. We are entering a recession based on my numbers."
On what President Obama and Congress could do if Bernanke doesn't have the ammunition:
"We certainly need another fiscal stimulus. Much stronger than the one we had before. The one we had before was not enough. Congress is controlled by the Republicans and they're going to vote against Obama in the realm of fiscal austerity. If things get worse, it's only to their political benefit."
"[The American Recovery and Reinvestment Act of 2009] was effective in the sense that the recession could have turned into a Great Depression. Things would have been much worse without it, so it was very effective in the sense of preventing a Great Depression, but it was not significant enough. With millions of unemployed construction workers, we need a trillion dollar, five-year program just for infrastructure, but it's not politically feasible and that's why there will be a fiscal drag and we will have a recession."
On the yield curve signaling not signaling a recession and whether there's a distortion with the reporting of the Fed:
"Traditionally, you can have inversion of the yield curve. Right now, we have policy rates at 0 and we cannot have this inversion of the curve, but the bond market as opposed to the stock market is expecting a recession. We're having a growth scare in spite of the worries about the credit risk of the sovereign. After the S&P downgrade, bond yields fell from 2.5% to 2% or below. The bond market is telling as a recession is coming and the flattening of the yield curve is telling us that. We cannot have an inversion because you can have negative long-term interest rates. That's the reason we don't see the inversion."
On Europe and what can be done to stop contagion:
"Not much is going to be enough. Once the FSF is passed they will run out of money in a matter of months and unless you triple the FSF or have euro bonds, then if Italy and Spain lose market access, there will not be enough money to back stop them...I don't think it is politically feasible to tell the German public they're going to backstop several trillion dollars of debt of that in the periphery. If we will not have a euro bond, what happened in the case of Greece will happen not just in an exceptional way as they said in Greece, but Portugal, Ireland and eventually Italy and Spain."
On whether there's anything to prevent a debt crisis from becoming a true systemic financial crisis:
"The banks in Europe are already in trouble. Banking risk has become sovereign risk when the banks were bailed out by the sovereigns, but now the sovereign risk is becoming banking risk because you have a bunch of distressed near insolvent sovereigns who cannot backstop their own banks. There is a good chunk of the government debt held by the banking system. It is a vicious circle between the sovereign risk and the banking risk. You cannot separate them. The current approach of the Europeans is to muddle through and kick the can down the road. Extent and pretend. It is not a stable equilibrium. It's an unstable disequilibrium. Either the Europeans go in the direction of a greater economic monetary fiscal and political union or the only other alternative is a disorderly default or work out and eventually break up of the monetary union."
On China and its growth prospects:
"China in the short term can maintain growth because there will be a severe recession and advanced economies will do more monetary and fiscal and credit stimulus. The reality is that their economy is imbalanced. Fixed investment has gone now to 50% of GDP. No country in the world can be so productive and take half of the output to invest into capital stock. You'll have a surge in public debt, it's already 80% of GDP including local government...I see a hard landing in China as the likely event, not this year or next year, but by 2013 when this over investment move will go bust."
"Even without the slowdown of the U.S., this over investment boom is going to go into a bust in a hard landing. We're going to have weakness in the U.S., Europe and Japan. That is going to accelerate the climate in which the weakening of China will occur."
On the possible debt exposure for Chinese banks:
"If you are looking at the Chinese banks, they have huge exposure to state and local governments and special purpose vehicles that have done the financing of the local investment. There has been at several trillion dollars yuans and we estimate 30% of these loans will go into default and become underperforming. The heat will be on the Chinese banks."
On Brazil:
"Brazil has some strong economic fundamentals...Our forecast that when the recession in advanced economies hits, economic growth in Latin America, including Brazil, is going to slow down as sharply next year compared to this year. Brazil has its own other domestic problems. If they do the structural reform that's needed, it could have high potential growth, but the question is whether the new president will be willing to do those structural reforms to reduce the distortion and increase the potential growth of the country. There may be some political economy constraints to doing that."


1 Sep 2011

The Financial World Is About To Hit The Big Red Panic Button

Most of the worst financial panics in history have happened in the fall.  Just recall what happened in 1929, 1987 and 2008.  Well, September 2011 is about to begin and there are all kinds of signs that the financial world is about to hit the big red panic button.  Wave after wave of bad economic news has come out of the United States recently, and Europe is embroiled in an absolutely unprecedented debt crisis.  At this point there is a very real possibility that the euro may not even survive.  So what is causing all of this?  Well, over the last couple of decades a gigantic debt bubble has fueled a tremendous amount of "fake prosperity" in the western world.  But for a debt bubble to keep going, the total amount of debt has to keep expanding at an ever increasing pace.  Unfortunately for the global economy, sources of credit are starting to dry up.  That is why you hear terms like "credit crisis" and "credit crunch" thrown around so much these days.  Without enough credit to feed the monster, the debt bubble is going to burst.  At this point, virtually the entire global economy runs on credit, so when this debt bubble bursts things could get really, really messy.
Nations and financial institutions would never get into debt trouble if they could always borrow as much money as they wanted at extremely low interest rates.  But what has happened is that lending sources are balking at continuing to lend cheap money to nations and financial institutions that are already up to their eyeballs in debt.
For example, the yield on 2 year Greek bonds is now over 40 percent.  Investors don't trust the Greek government and they are demanding a huge return in order to lend them more money.
Throughout the financial world right now there is a lot of fear.  Lending conditions have gotten very tight.  Financial institutions are not eager to lend money to each other or to anyone else.  This "credit crunch" is going to slow down the economy.  Just remember what happened back in 2008.  When easy credit stops flowing, the dominoes can start falling very quickly.
Sadly, this is a cycle that can feed into itself.  When credit is tight, the economy slows down and more businesses fail.  That causes financial institutions to want to tighten up things even more in order to avoid the "bad credit risks".  Less economic activity means less tax revenue for governments.  Less tax revenue means larger budget deficits and increased borrowing by governments.    But when government debt gets really high that can cause huge economic problems like we are witnessing in Greece right now.  The cycle of tighter credit and a slowing economy can go on and on and on.
I spend a lot of time talking about problems with the U.S. economy, but the truth is that the rest of the world is dealing with massive problems as well right now.  As bad as things are in the U.S., the reality is that Europe looks like it may be "ground zero" for the next great financial crisis.
At this point the EU essentially has three choices.  It can choose much deeper economic integration (which would mean a huge loss of sovereignty), it can choose to keep the status quo going for as long as possible by providing the PIIGS with gigantic bailouts, or it can choose to end of the euro and return to individual national currencies.
Any of those choices would be very messy.  At this point there is not much political will for much deeper economic integration, so the last two alternatives appear increasingly likely.
In any event, global financial markets are paralyzed by fear right now.  Nobody knows what is going to happen next, but many now fear that whatever does come next will not be good.
The following are 25 signs that the financial world is about to hit the big red panic button....
#1 According to a new study just released by Merrill Lynch, the U.S. economy has an 80% chance of going into another recession.
#2 Will Bank of America be the next Lehman Brothers?  Shares of Bank of America have fallen more than 40% over the past couple of months.  Even though Warren Buffet recently stepped in with 5 billion dollars, the reality is that the problems for Bank of America are far from over.  In fact, one analyst is projecting that Bank of America is going to need to raise 40 or 50 billion dollars in new capital.
#3 European bank stocks have gotten absolutely hammered in recent weeks.
#4 So far, major international banks have announced layoffs of more than 60,000 workers, and more layoff announcements are expected this fall.  A recent article in the New York Times detailed some of the carnage....
A new wave of layoffs is emblematic of this shift as nearly every major bank undertakes a cost-cutting initiative, some with names like Project Compass. UBS has announced 3,500 layoffs, 5 percent of its staff, and Citigroup is quietly cutting dozens of traders. Bank of America could cut as many as 10,000 jobs, or 3.5 percent of its work force. ABN Amro, Barclays, Bank of New York Mellon, Credit Suisse, Goldman Sachs, HSBC, Lloyds, State Street and Wells Fargo have in recent months all announced plans to cut jobs — tens of thousands all told.
#5 Credit markets are really drying up.  Do you remember what happened in 2008 when that happened?  Many are now warning that we are getting very close to a repeat of that.
#6 The Conference Board has announced that the U.S. Consumer Confidence Index fell from 59.2 in July to 44.5 in August.  That is the lowest reading that we have seen since the last recession ended.
#7 The University of Michigan Consumer Sentiment Index has fallen by almost 20 points over the last three months.  This index is now the lowest it has beenin 30 years.
#8 The Philadelphia Fed's latest survey of regional manufacturing activity was absolutely nightmarish....
The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, decreased from a slightly positive reading of 3.2 in July to -30.7 in August. The index is now at its lowest level since March 2009
#9 According to Bloomberg, since World War II almost every time that the year over year change in real GDP has fallen below 2% the U.S. economy has fallen into a recession....
Since 1948, every time the four-quarter change has fallen below 2 percent, the economy has entered a recession. It’s hard to argue against an indicator with such a long history of accuracy.
#10 Economic sentiment is falling in Europe as well.  The following is from a recent Reuters article....
A monthly European Commission survey showed economic sentiment in the 17 countries using the euro, a good indication of future economic activity, fell to 98.3 in August from a revised 103 in July with optimism declining in all sectors.
#11 The yield on 2 year Greek bonds is now an astronomical 42.47%.
#12 As I wrote about recently, the European Central Bank has stepped into the marketplace and is buying up huge amounts of sovereign debt from troubled nations such as Greece, Portugal, Spain and Italy.  As a result, the ECB is alsomassively overleveraged at this point.
#13 Most of the major banks in Europe are also leveraged to the hilt and have tremendous exposure to European sovereign debt.
#14 Political wrangling in Europe is threatening to unravel the Greek bailout package.  In a recent article, Satyajit Das described what has been going on behind the scenes in the EU....
The sticking point is a demand for collateral for the second bailout package. Finland demanded and got Euro 500 million in cash as security against their Euro 1,400 million share of the second bailout package. Hearing of the ill-advised side deal between Greece and Finland, Austria, the Netherlands and Slovakia also are now demanding collateral, arguing that their banks were less exposed to Greece than their counterparts in Germany and France entitling them to special treatment. At least, one German parliamentarian has also asked the logical question, why Germany is not receiving similar collateral.
#15 German Chancellor Angela Merkel is trying to hold the Greek bailout deal together, but a wave of anti-bailout "hysteria" is sweeping Germany, and nowaccording to Ambrose Evans-Pritchard it looks like Merkel may not have enough votes to approve the latest bailout package....
German media reported that the latest tally of votes in the Bundestag shows that 23 members from Mrs Merkel's own coalition plan to vote against the package, including twelve of the 44 members of Bavaria's Social Christians (CSU). This may force the Chancellor to rely on opposition votes, risking a government collapse.
#16 Polish finance minister Jacek Rostowski is warning that the status quo in Europe will lead to "collapse".  According to Rostowski, if the EU does not choose the path of much deeper economic integration the eurozone simply is not going to survive much longer....
"The choice is: much deeper macroeconomic integration in the eurozone or its collapse. There is no third way."
#17 German voters are against the introduction of "Eurobonds" by about a 5 to 1 margin, so deeper economic integration in Europe does not look real promising at this point.
#18 If something goes wrong with the Greek bailout, Greece is financially doomed.  Just consider the following excerpt from a recent article by Puru Saxena....
In Greece, government debt now represents almost 160% of GDP and the average yield on Greek debt is around 15%. Thus, if Greece’s debt is rolled over without restructuring, its interest costs alone will amount to approximately 24% of GDP. In other words, if debt pardoning does not occur, nearly a quarter of Greece’s economic output will be gobbled up by interest repayments!
#19 The global banking system has a total of 2 trillion dollars of exposure to Greek, Irish, Portuguese, Spanish and Italian debt.  Considering how much the global banking system is leveraged, this amount of exposure could end up wiping out a lot of major financial institutions.
#20 The head of the IMF, Christine Largarde, recently warned that European banks are in need of "urgent recapitalization".
#21 Once the European crisis unravels, things could move very rapidly downhill.  In a recent article, John Mauldin put it this way....
It is only a matter of time until Europe has a true crisis, which will happen faster – BANG! – than any of us can now imagine. Think Lehman on steroids. The U.S. gave Europe our subprime woes. Europe gets to repay the favor with an even more severe banking crisis that, given that the U.S. is at best at stall speed, will tip us into a long and serious recession. Stay tuned.
#22 The U.S. housing market is still a complete and total mess.  According to a recently released report, U.S. home prices fell 5.9% in the second quarter compared to a year earlier.  That was the biggest decline that we have seen since 2009.  But even with lower prices very few people are buying.  According to the National Association of Realtors, sales of previously owned homesdropped 3.5 percent during July.  That was the third decline in the last four months.  Sales of previously owned homes are even lagging behind last year's pathetic pace.
#23 According to John Lohman, the decline in U.S. economic data over the past three months has been absolutely unprecedented.
#24 Morgan Stanley now says that the U.S. and Europe are "hovering dangerously close to a recession" and that there is a good chance we could enter one at some point in the next 6 to 12 months.
#25 Minneapolis Fed President Narayana Kocherlakota says that he is so alarmed about the state of the economy that he may drop his opposition to more monetary easing.  Could more quantitative easing by the Federal Reserve soon be on the way?
Things have not looked this bad for global financial markets since 2008.  Unless someone rides in on a white horse with trillions of dollars (or euros) of easy credit, it looks like we are headed for a massive credit crunch.
What we witnessed back in 2008 was absolutely horrifying.  Very few people want to see a repeat of that.  But as things in the U.S. and Europe continue to unravel, it appears increasingly likely that the next wave of the financial crisis could hit us sooner rather than later.
None of the fundamental problems that caused the crisis of 2008 have been fixed.  The world financial system is still one gigantic mountain of debt, leverage and risk.
Authorities around the globe will certainly do all they can to keep things stable, but in the end it is inevitable that the house of cards is going to come crashing down.
Let us hope for the best, but also prepare for the worst.

Fed's Bullard: QE3 possible if inflation eases

The US Federal Reserve could embark on a third round of quantitative easing depending on upcoming economic data, St Louis Fed president James Bullard says.
In an interview published in the Asahi newspaper today, Mr Bullard said he would want to confirm that inflation has eased before launching a third round of quantitative easing.
The US economy is likely to grow 2.5 per cent in the second half of the year, the Asahi also quoted Mr Bullard as saying.
Expectations are growing that the central bank could ease policy at its two-day meeting starting September 20 after minutes from last month's gathering showed some policymakers pressed for bold and unconventional steps to shore up a flagging economy.
"Depending on future economic data QE3 is one choice, but we need to gather information about how the economy will perform in the second half of the year," Mr Bullard said in the Asahi, referring to the Fed's quantitative easing programme where it buys government debt.
"Before any moves, I would like to confirm that inflation is easing."
The head of the St Louis branch does not have a vote on the policy-setting Federal Open Market Committee this year.
Mr Bullard reiterated his view that if the Fed were to buy additional government debt it should do so incrementally, on a meeting-by-meeting basis. Bullard is known for his hawkish views on monetary policy.
The US economy is likely to grow 2.5 percent in the second half of the year, the Asahi also quoted Bullard as saying.
The Fed has completed a $US600 billion quantitative easing bond-buying programme, known as QE2. In addition, US interest rates are already near zero and the Fed has signalled it is willing to hold borrowing costs at that level for two years if necessary.
The minutes from the Fed’s August meeting revealed that the FOMC's pledge to keep US rates low until mid-2013 drew an unprecedented three dissenters.  In contrast, a "few" members thought that an even "more substantial move" was justified at this meeting.
What is clear is from these minutes is that the range of tools now available to the Fed is becoming increasingly limited, with some members increasingly concerned that the costs, for example in terms of inflationary consequences, may ultimately outweigh the benefits, ANZ said in a report this morning.
‘‘But with FOMC members apparently split on whether the US economy even warrants further monetary policy accommodation, the hurdle for another round of QE is high’’, the bank said.

Read more:

31 Aug 2011

According To JPM QE3 Is Now A "Better-Than-Even Chance" On September 21

For now it was just Jan Hatzius calling for QE3 now if not sooner. With the addition of JPM to the list of banks now implicitly expecting (read demanding) QE3, it is now quite clear how Wall Street feels - after all someone has to pay those Wall Street bonuses - it sure won't come from M&A activity, underwriting of Chinese IPO frauds, or trading volume. Here is the key sentence from a just released note by JPM's Michael Feroli: "We believe the minutes lend themselves to our view that there is a somewhat better-than-even chance the Fed takes action at the next meeting to increase the average maturity of assets on their balance sheet." Keep an eye on the market tomorrow for confirmation: a third day of the same low volume meltup we have seen this week should make the open QE3 question into case closed.
From JPM:
Sometimes the squeaky wheel doesn't get the oil
The hawks on the FOMC may generate a fair amount of media attention, but today's minutes to the August 9th meeting remind us that there is a less vocal dovish faction that favors even more aggressive policy easing, and their view has been winning out over time. This contingent of "a few" favored a "more substantial move" at the recent FOMC meeting, "but they were willing to accept" the mid-2013 rate guidance "as a step in the direction of additional accommodation." While the change to forward guidance was one such step, other steps discussed included the usual three: further enhancements to forward guidance, further asset purchases, and lowering the interest on excess reserve rate. Inflation targeting, price level targeting, and other more extreme measures were not discussed. We believe the minutes lend themselves to our view that there is a somewhat better-than-even chance the Fed takes action at the next meeting to increase the average maturity of assets on their balance sheet.

Regarding enhanced communications, there was a relatively lengthy discussion of conditioning the fed funds rate guidance on explicit numerical values for the unemployment rate or the inflation rate. A similar policy was undertaken by the BoJ several years back, when they conditioned the continuance of zero interest rate policy (ZIRP) on inflation remaining negative. While some on the FOMC argued in favor of this strategy, the only downside that was mentioned in the minutes was "questions about how an appropriate numerical value might be chosen." Given the Committee added a day to the next meeting to discuss easing options, some further communications enhancement at the next meeting cannot be ruled out.

On balance sheet policy, "some participants noted that additional asset purchases could be used to provide more accommodation." The minutes then went on to note that "others" favored an Operation Twist, perhaps of the active version, to extend the maturity of the Fed's assets holdings by actively selling short maturity assets from the Fed's balance sheet and buying more longer maturity assets. It was noted that this "would have a similar effect" on long term rates as more outright purchases, but would "not boost the size of the Federal Reserve's balance sheet and the quantity of reserve balances." It was not explicitly spelled out why either of these latter two variables should matter, but reading between the lines it could be the case that concern about the adverse political and public reaction to an increase in the monetary base may be leaving Fed policymakers hesitant to undertake another large expansion of the balance sheet. The discussion on lowering IOER was very terse, as "a few participants noted" that it could be "helpful in easing financial conditions."

Stepping away from the discussion of policy options, the Committee's discussion of current conditions and the economic outlook was an exercise in dreariness. The economy's performance so far "was considerably slower than they had expected," uncertainty has "risen appreciably," and "most participants saw increased downside risks to the outlook for economic growth."

Goldman Presents The Three "Radical" Measures The Fed May Engage In To Turbocharge An Imminent QE3

Goldman is not used to being snubbed when it comes to its policy recommendations. Which is what essentially happened during the Jackson Hole speech in which Bernanke left the QE3 door slightly open... but not enough to appease Bernanke's Goldman alum superior at the New York Fed. As such, since at least a few days have passed without Goldman reminding of who calls the shots, here is probably the most comprehensive summary of the Jackson Hole aftermath, and what the market will now expect to come out of the Fed on September 21. Whether Bernanke will go ahead and listen to Goldman, is unknown - the Fed risks incurring the wrath of Goldman at its own peril. What is perhaps most interesting about self-Q&A are the Goldman  proposed "radical" measures that the Fed could consider to employ in addition to LSAP and Twist which so far have proven to be ineffective: "There are three main ways in which the Fed could be more radical:(1) an extension of the QE program into markets other than Treasuries and agency MBS, e.g., private sector securities, (2) a much bigger QE program, up to the extreme version of a promise to buy as many securities as needed to hit a specific yield target (i.e. a "rate cap" further out on the yield curve as then-Governor Bernanke suggested back in 2002), and (3) an explicit or implicit change in the Fed's policy targets." If these are truly hints as to what the Fed should do, then we hope readers have their gold $3000 calls firmly in place.
That said, to end once and for all all ridiculous debates over what is and what isn't QE3, here is Goldman with the most spot on definition of what further easing is and will be: "One final note on terminology: for simplicity, we have decided to label as "QE" any program of large-scale asset purchases that removes a significant amount of duration from the market, regardless of whether it is financed by creation of excess reserves or sales of short-duration securities. This is a little sloppy, but we believe that the economic distinction between the two modes of financing is so small--and the term "QE2" is already so well established--that we want to refer to them with the same basic term." Hence people can stop referencing momentum chasing FX traders in attempting to make their case of why Operation Twist is not QE3.
Q&A on Monetary Policy after Jackson Hole
Q: Will Fed officials ease monetary policy further?
A: Yes, we think so. At this point, we believe that the majority of the FOMC expects real GDP growth of around 2.5% in the second half of 2011, and perhaps 3% in 2012. As a result of growth that averages a bit above trend through the end of next year, the committee "…anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate." Our own expectation is that real GDP growth will average nearly 1 percentage point below the committee's likely forecast and that the unemployment rate will go sideways to slightly higher. If we are right and the committee ultimately reduces its growth and employment forecast accordingly, we think that this shift in view will be accompanied by further monetary easing.
That said, additional easing is not a certainty. Following Monday's better-than-expected personal spending report for July, it looks like real GDP in Q3 may come in a bit stronger than our forecast of just 1% (annualized). Moreover, inflation has continued to come in on the higher side of expectations, and the "hard" economic data for July have been stronger than anticipated. If growth and inflation exceed our forecasts, additional easing would become less likely.
Q: Should Fed officials ease monetary policy further?
A: Yes, we think so. The US economy has a large--and probably increasing--amount of excess capacity, at a time when fiscal policy is already primed for restraint. Thus, the risks to the attainment of the Fed's dual mandate of maximum employment and low inflation are clearly tilted to the weak side at the current stance of monetary policy, which implies that further easing is a natural expectation. Indeed, our QE-adjusted Taylor rule--which is based on the Fed's past response to unemployment and inflation gaps as well as our estimates of the effectiveness of unconventional monetary policy--implies a need for additional easing equivalent to a cut in the funds rate by around 200bp.
There are two main arguments against further easing, but we don’t find them very compelling. The first is that "QE2 didn't work, so why should QE3 be any better?" We disagree with the view that QE2 didn't work. It is true that QE2 failed to ignite a more powerful recovery. However, we would attribute this to the combination of an even more adverse "baseline" pace of growth than we (and the Fed) had expected, and to the increase in oil prices. Moreover, our commodity strategists believe that most of the increase in oil prices was due to the tightening demand/supply situation in the oil market, exacerbated by the turmoil in the Middle East. Our belief that the moves in oil prices have been mainly driven by supply and demand rather than monetary policy is also consistent with the easing in oil prices over the past few weeks--a period in which the economic indicators have deteriorated and expectations of QE3 have grown.
The second argument against further easing is that most of the problems in the economy are not easily addressed by monetary policy but require either fiscal solutions or simply time. We agree that monetary policy is unlikely to be very powerful, but we do think that it would add a few tenths to GDP growth and would not have significant costs in terms of inflation given the large amount of slack in the economy (see "How Much Growth Boost to Expect from QE3?" US Daily, August 24, 2011). Ultimately, the question whether to ease is a cost-benefit calculation, and the benefits exceed the costs in our view.
Q: If it happens, what form will the easing take?
A: In his recent monetary policy testimony, Chairman Bernanke noted three ways of providing additional stimulus: (1) more explicit guidance about future policy, (2) changes in the size or composition of the Fed balance sheet, and (3) a cut in the interest rate on excess reserves (IOER) from its current 25 basis points (bp).
By stating their expectation that the funds rate will stay exceptionally low until at least mid-2013, Fed officials have already gone as far as they are likely to go with respect to (1). Moreover, while a cut in the IOER as per (3) is possible, it is unlikely to have a sizable effect given that the effective funds rate is only 8-9bp at present. This leaves (2) as the most straightforward option. Specifically, our current baseline expectation is a renewed asset purchase program that removes a similar amount of duration from the marketplace as the QE2 program announced last November. However, we think there will be some "tweaks" compared with QE2 that would be mostly designed to reduce the potential for "backlash" against the Fed at home and abroad. One possibility would be to finance the asset purchases via sales of shorter-duration securities as opposed to the creation of excess bank reserves (see "For More Easing, Will the Fed Go Big or Go Long?" US Daily, August 15, 2011). The advantage is that such a "twist" does not imply another controversial expansion in the Fed's balance sheet. Another possibility--not necessarily mutually exclusive--would be to announce not the ultimate amount of purchases but only a "run rate" that is reevaluated at each FOMC meeting and remains in place until further notice.
One final note on terminology: for simplicity, we have decided to label as "QE" any program of large-scale asset purchases that removes a significant amount of duration from the market, regardless of whether it is financed by creation of excess reserves or sales of short-duration securities. This is a little sloppy, but we believe that the economic distinction between the two modes of financing is so small--and the term "QE2" is already so well established--that we want to refer to them with the same basic term (see "QE2 as a Shortening of Treasury Debt Maturities," US Daily, October 25, 2010). (We draw the line at an increase in portfolio duration that is effected only through the reinvestment of MBS paydowns; we do not call this QE.)
Q: What assets would they buy?
A: Probably mostly longer-duration Treasuries. To be sure, the recent widening in agency MBS spreads has somewhat raised the probability that Fed officials might go back into that market, and a further widening could raise it further. It is also possible that MBS would be incorporated into a possible "twist" via sales of high-coupon securities (which have relatively short duration because of a higher probability of refinancing/prepayments) and purchases of low-coupon securities (which have relatively long duration). However, we think the hurdle against duration extension in the MBS market is relatively high because Fed officials remain determined to return to an all-Treasury balance sheet in the longer term. An increase in the stock of low-coupon securities that may not roll off the balance sheet for up to 30 years would make this process even more challenging.
Q: What is the timing?
A: The key question is what happens to the FOMC's forecasts. We suspect that the current forecast is not yet weak enough to lead to another big easing step, on top of the substantial change in forward-looking language at the August meeting. Based on our forecasts for the near-term economic data--including a 50,000 gain in nonfarm payrolls, a flat 9.1% unemployment rate, and a 48.5 ISM--we also do not expect a large downgrade in the forecast. As a result, our base case for September 20-21 is for the FOMC to state its intention to reinvest MBS paydowns at the longer-end of the Treasury yield curve, but only to signal the possibility of a larger program at a later date.
However, this is a close call. For one thing, our assessment of likely changes in the FOMC forecast could change in response to new information about the economy, including substantial disappointments in this week's economic data. Moreover, it is possible that the FOMC leadership has already decided to take another big step but is still building the internal support (we noted this possibility just after the last meeting; see "QE3 Now Our Base Case," US Daily, August 9, 2011). But our best guess is that a big step will only come a bit later.
Q: Does the Fed have more extreme options up its sleeve?
A: Yes, but the hurdles are very high, and a more radical approach is unlikely unless the economy and/or the financial markets perform substantially worse than we are forecasting. There are three main ways in which the Fed could be more radical: (1) an extension of the QE program into markets other than Treasuries and agency MBS, e.g., private sector securities, (2) a much bigger QE program, up to the extreme version of a promise to buy as many securities as needed to hit a specific yield target (i.e. a "rate cap" further out on the yield curve as then-Governor Bernanke suggested back in 2002), and (3) an explicit or implicit change in the Fed's policy targets.
Regarding (1), the general understanding of the Federal Reserve Act is that it does not allow purchases of assets which could result in an outright loss for the Fed. Therefore, a purchase of private sector assets such as nonconforming mortgages or corporate bonds (let alone equities or real estate) almost certainly requires funding from Congress, which is unlikely to materialize unless the level of distress in the economy or the markets rises sharply.
Regarding (2), while our base case is a QE program that removes a similar amount of duration as QE2, a bigger and bolder approach is certainly possible. The bigger the program, the more likely it is that it would ultimately need to involve a sizable expansion in the Fed's balance sheet because the scope for a "twist" reaches its natural limits. However, the limiting case of a "rate cap" would again require an extreme situation. Fed officials would undoubtedly worry about the tail risk that they might need to buy up the entire supply of securities in the targeted sector to make good on their promise.
Finally, regarding (3), we have again received some questions about the possibility that the FOMC might move to a nominal GDP target (see "The Fed Discusses Easing Options," US Daily, October 12, 2010, as well as this week's Economics Focus in The Economist). It's important to note that depending on the interpretation, the Fed's dual mandate (in which policy responds to both employment/real GDP and inflation) already has some similarities with a nominal GDP target (in which policy responds to the product of real GDP and the price level). The key differences are that (1) an announced nominal GDP target is much simpler and therefore more powerful than the hazier dual mandate, which is interpreted differently by different people; and more importantly, (2) the dual mandate is defined in terms of rate of change of prices, while a nominal GDP target depends on the level of prices. (There is not such a clear distinction with respect to the employment/real GDP component, which is typically understood to refer to levels in the dual mandate definition as well.) The implication is that a nominal GDP target, Fed officials attempt to "make up" for past undershooting of inflation via future overshooting. In other words, a move to a nominal GDP target is tantamount to a temporary increase in the inflation target. We believe that the skepticism expressed by Chairman Bernanke's in his 2010 Jackson Hole speech still applies, and do not expect a move to either a higher inflation target or a nominal GDP target.