Fed launches QE-lite
In a compromise, the Federal Open Market Committee (FOMC) has approved a cautious and conservative second round of quantitative easing (QE2) which may satisfy nobody but should prevent internal splits from widening.
It is designed to provide some marginal stimulus to asset markets and economic recovery without further undermining the confidence of foreign investors.
The best way to characterize the $600 billion bond-buying program implemented over eight months is “QE-lite”. The total is slightly higher than expected, but spread over a slightly longer period. The Fed has done almost exactly what it signaled over the last few weeks — no more (there was no “shock and awe”) and no less.
There is an implicit commitment to continue buying securities until the end of June 2011 and to buy $600 billion in total but the figures are described as an intention, so they could be varied in response to changing conditions.
The committee preserved its flexibility by promising to “regularly review the pace of its securities purchases and the overall size of the asset-purchase program in the light of incoming information and will adjust the program as needed”.
Supporters of large-scale, open-ended asset purchases will note there is no finite end to the program. The committee pledged to continue employing all the policy tools at its disposal “as necessary to support the economic recovery and ensure that inflation, over time, is at levels consistent with its mandate”. It was the Fed’s equivalent of “all necessary means”.
Opponents will be relieved the committee has only sanctioned $600 billion so far, a relatively moderate amount. The regular review means even this could be halted early or scaled back if conditions improve or inflation and commodity prices start to accelerate too much.
After all the thunderous commentary for and against QE2, the Fed has labored mightily and brought forth a mouse. The program’s impact has been mostly priced in already, which explains the muted market reaction following the announcement.
In any event, the proposed buying is too small to shave more than a few basis points off borrowing costs in the targeted 5-10 year segment of the curve. At a time when rates are already having a minimal impact on investment and job creation, the stimulus will probably be marginal. On the other hand, purchases are likely not large enough to trigger rampant monetisation and inflation.
The committee seems to have argued itself into a stalemate. QE2 supporters could not do more without appearing to stoke a destabilizing bubble in asset markets and take a dangerous gamble with both asset prices and inflation. QE2 opponents successfully dramatized the costs and risks of a large-scale, open-ended program but lacked the votes to block it altogether.
The idea had run much too far for the Fed to abandon it now.
BERNANKE THE COLUMNIST
In many ways the most interesting development was Fed Chairman Ben Bernanke’s decision to contribute an opinion column to the Washington Post overnight to explain “What the Fed did and why: supporting the recovery and sustaining price stability”.
Bernanke’s column is unprecedented. By convention, members of the Federal Open Market Committee observe a “black out period” on monetary policy and economic issues for about a week prior to committee meetings and slightly longer afterward. The agreed statement released following the conclusion of each meeting is meant to speak for itself.
Unlike the European Central Bank, which gives a detailed press conference and provides an opportunity for reporters to ask questions, the Fed has always directed investors and the public to its agreed statement and made them wait for the publication of the meeting’s minutes weeks later.
It is a sign of the immense pressure the Fed is now under that the chairman felt obliged to break this convention and provide a much lengthier justification for the committee’s decision than was possible in the normal statement.
As I have noted elsewhere, the Fed must win the “spin war” over the presentation to QE2. It has to ensure asset purchases are seen as a prudent but effective means to stimulate investment, growth and jobs and raise inflation towards its target, rather than a “a bargain with the devil” as one leading opponent called them.
The Fed must appear in control, not buffeted by events. Bernanke needs to seem like the sorcerer rather than the sorcerer’s apprentice. The Washington Post column is the opening shot in what is likely to be a prolonged spin war to shape investors’ expectations about the likely effectiveness and impact of QE2.
In comments that may come back to haunt him, Bernanke was candid about the extent to which the Fed’s strategy now rests on influencing asset prices:
“Easier financial conditions will promote economic growth … lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending”.
Bernanke admitted QE strategies were “less familiar” than policies that employ interest rates as their main tool. He insisted “that is one reason the FOMC has been cautious, balancing the costs and benefits before acting”. He pledged regular reviews to ensure it is “working as intended”.
And in response to his critics, he promised “we have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time”.
NOW BACK TO THE REAL ECONOMY
The formal announcement of QE2, including its likely scale and duration, have removed an important source of uncertainty for investors. It has given a clear signal short-term interest rates will not rise much if at all until late in 2011 at the earliest. Yields will also likely to remain lower than they otherwise would at a corresponding period in the recovery. The Fed has given clear encouragement for the “risk on” trade.
With much of the monetary uncertainty now removed for more than six months, investors’ attention, and attendant volatility will likely shift back to the performance of the real economy, where indicators have recently been moderately encouraging. Business surveys point to continued expansion. Unemployment remains high but is a lagging indicator.
It is the real economy’s resilience, slow but powerful operation of cyclical effects, and gradual adaptation to structural change, which caused Kansas City Fed President Thomas Hoenig to renew his dissent and oppose QE2.
The most likely scenario is for continued, albeit perhaps sluggish and disappointing growth, to continue through H1 2011. In which case, QE2 may come to be seen as largely irrelevant but mostly harmless.
That would certainly be the best outcome for all concerned. Because if growth really does falter and inflation continues to fall, QE2 is not enough to prevent it. And if commodity prices rise and asset bubbles continue to expand, the Fed has no real exit option. No one has yet found an easy way to deflate bubbles gradually.