MacroScope

For all the talk about clear communications at the Federal Reserve, central bank Vice Chair Janet Yellen’s speech to the Society of American Business and Economics Writers ran a rather long-winded 16 pages.

However, while Fed board members generally do not take questions from reporters, there was a scheduled audience Q&A which, at this particular event, meant it was effectively a press briefing.

So I asked Yellen, seen as a potential successor to Fed Chair Ben Bernanke when his second term ends early next year, what she thought of Japan’s decision to launch a bold $1.4 trillion stimulus to fight a long-standing problem of deflation and economic stagnation.

This is what she said:

I prefer not to comment on the details of what the Bank of Japan announced. But I’d certainly say that here’s a country that’s suffered deflation for well over a decade and had very weak economic growth.

When you contemplate the fact that nominal income, nominal GDP in Japan today is slightly lower than it was I think 20 years ago – I mean that’s really remarkable and has resulted in all kinds of problems for Japan. So I really think that taking an aggressive approach to try to end deflation is something I certainly understand.

When Federal Reserve Chairman Ben Bernanke was last in New York, he joked about his past research into the effect of uncertainty on investment spending. “I concluded it is not a good thing, and they gave me a PhD for that,” he said, drawing laughter from a gathering of hundreds of economists in a packed Times Square conference room.

Laughter probably wasn’t echoing through the halls of the U.S. central bank on Wednesday. Late on Tuesday, Congress struck a last-minute deal that only partially and temporarily avoids the so-called fiscal cliff. Bernanke and other Fed policymakers – frustrated that it took politicians so long to address tax and spending levels in the first place – were hoping Washington would agree to a bi-partisan, longer-term plan to narrow the country’s massive deficit with only modest near-term fiscal restraint. While no deal on taxes would have been far worse for the economy, the fact that Congress put off decisions on government spending and the debt ceiling for another two months simply prolongs the uncertainty that many feel is holding back investments by businesses and households.

“You basically continue this fiscal policy uncertainty that we have had for the past year or more,” said Roberto Perli, managing director of policy research at International Strategy and Investment Group. In a note to clients, Perli predicted that at best the fiscal cliff deal does not change the outlook for Fed policy, which for now consists of rock-bottom interest rates and $85 billion per month in asset purchases. But more likely, he wrote, it would lead to even more accommodation from the Fed since Republicans – smarting from a political defeat in the last few days – may prefer to let the “sequester” of large-scale spending cuts kick in as scheduled on March 1 rather than agreeing to a smaller reduction in U.S. debt. In that case, the Fed would respond by keeping rates lower for longer, perhaps through early 2016, or simply by ramping up the value of asset purchases under its quantitative easing program (QE3), Perli wrote.

By almost all accounts, the Federal Reserve is expected to “stay the course” on its massive bond-buying program after next week’s policy-setting meeting. That would mean a continuation of the $85 billion/month in total purchases of longer-term securities, probably consisting of $40 billion in mortgage bonds and another $45 billion in Treasuries. Laurence Meyer of Macroeconomic Advisers is one of countless forecasters predicting this, calling it the “status quo.”

Problem is, the U.S. central bank’s current policy is not simply to buy $85 billion in bonds — and if it does announce such a program on Wednesday, it should probably be interpreted as policy easing, not a continuation of current policy.

The $45 billion in longer-term Treasuries is part of a program called Operation Twist that offsets those purchases with $45 billion in sales of shorter term Treasuries. In June, Fed policymakers extended Twist to the end of the year, meaning the market — which rallies each time the Fed eases policy — should have priced in an end to the $45 billion shuffle in the Fed’s portfolio of assets. It also means that there is really only $40 billion in outright bond-buying happening today, as part of the Fed’s third round of quantitative easing (QE3). Not $85 billion.

The Federal Reserve has kept its key federal funds rate at near-zero for four straight years, and it expects to keep it there for at least two more. But with each trip around the sun, outsiders wonder whether central bank policymakers will act without hesitation when the time finally comes to tighten monetary policy?

This week, the official with his hand on the Fed’s interest-rate lever, so to speak, asked that same question. Simon Potter, head of the Federal Reserve Bank of New York’s open market operations, was at NYU‘s Stern School of Business discussing the various ways the central bank can tighten policy: the federal funds rate; the interest rate on excess bank reserves; reverse repurchase agreements. Potter runs the unit that carries out Fed policy in the market, and sits in on most policy-setting meetings in Washington. Asked by a student about the inflationary or deflationary risks associated with tightening policy in the future, he had this to say:

The real heart of that question is a willingness one. I’m pretty confident we have the technical ability to raise rates. The hard part will be the willingness in some people’s minds. What I’ve seen among most people in financial markets is they’re pretty sure that the Fed will raise rates when it’s appropriate to do it… Definitely compared to 2009-2010, the type of hedge funds and people who took large bets thinking this would lead to high inflation have given up on that bet.

During a Q&A at the Brookings Institution last week, former Fed Vice Chairman Donald Kohn asked new board member Jeremy Stein, formerly a Harvard professor, about the impression that the Fed’s quantitative easing was only helping wealthy people who benefit most from rising stocks.

“How do you deal with this sense that the effects of policy aren’t being equitably felt in all parts of society,” asked Kohn, who worked at the Fed for four decades before stepping down in 2010, and is now a Brookings Fellow.

Stein, who joined the Fed’s influential Washington-based board in May as a governor, suggested this was not an entirely fair accusation given the wide-ranging effects of the policy. Here’s how he explained it:

Deutsche Bank economists have tried to quantify what effect QE3 is likely to have on the U.S. economy. For an assumed $800 billion of purchases of both agency securities and Treasuries through the end of next year, the economy gets a little over half a percentage point lift over the course of two years and a net 500,000 jobs – or about two months’ worth of job creation in a typical strong recovery from recession.

In a model-driven assessment based on the past impact of QE1 and QE2, Deutsche Bank Securities chief economist Peter Hooper says this is what the Federal Reserve printing another $800 billion — slightly less than the gross domestic product of Australia — will do:

1. Reduce the 10-year Treasury yield by 51 bps

2. Raise the level of real GDP by 0.64%

3. Lower the unemployment rate by 0.32 percentage points

4. Increase house prices by 1.82%

5. Boost the S&P 500 by 3.06%, and

6. Raise inflation expectations by 0.25%

Apart from the fact we are more likely to win a lottery jackpot of epic proportions than see all of those predictions come true to that degree of precision, the pressing question is whether a 0.32 percentage point reduction in the unemployment rate would be significant enough for the Fed to stop printing money. After all, the Fed tied whether or not it would be satisfied by the results of QE3 to a substantial improvement in the labour market.

In a historic shift in the way the Federal Reserve conducts monetary policy, the U.S. central bank last week announced an open-ended quantitative easing program where it has committed to continue buying assets until the country’s employment outlook improves substantially. Bank of America-Merrill Lynch credit analysts captured Wall Street’s reaction:

With an open-ended QE program to buy agency mortgages, and an extremely dovish statement, the Fed managed to provide a positive surprise for a market that was expecting a lot.

The new plan is really not that different from adopting a defacto growth target. Still, given the lack of complete consensus on the matter within the Fed, its Chairman Ben Bernanke was forced to stick with words rather than numbers to convey his message of central bank commitment. From the Federal Open Market Committee Statement:

“Will he or won’t he?” That’s what investors, traders and policy-watchers in the financial markets are pondering, frozen at their terminals waiting to find out if Federal Reserve Chairman Ben Bernanke will persuade his colleagues to print more money this week.

Among economists who work for primary bond dealers, the firms who sell government bonds directly to the Fed, there’s a striking conviction rate that he will, 68 percent, according to the latest Reuters Poll of probabilities.

The wider forecasting community isn’t far behind, at 65 percent.

While that kind of probability is more than enough to make people paid handsomely to take huge bets with other people’s money to confidently say something is a done deal, the real policy decision is probably a lot closer.

(Corrects to show CRT is not a primary dealer)

Bond bulls are ready to charge after Friday’s July U.S. employment data, according to a survey by Ian Lyngen, senior government bond strategist at primary dealer CRT Capital Group.

Says Lyngen:

Despite the vacation season and the multitude of ‘out of office’ responses we got, participation in this month’s survey was above-average and consistent with a market that’s engaged for the big policy/data events of the summer. As for the results of the survey, in a word: BULLISH.

Lyngen argued the survey results were the most bullish since November 2010, a point that was followed by a selloff that brought 10-year yields from 2.55 percent to 3.75 percent over the following four months.

Pity the Federal Reserve. Like an over-hyped Olympian, the U.S. central bank enters this week’s policy meeting with sky-high expectations and a high probability of disappointment.

Markets are salivating at the prospect of a decisive easing move when Fed policymakers emerge from their meeting on Wednesday. The S&P 500 is up 3.6 percent in the last four sessions as traders hold out hope the Fed will launch a third round of quantitative easing, or QE3, to blast the U.S. economy out of its funk. Stumbling job creation, manufacturing and spending, as well as a measly 1.5 percent GDP growth in the second quarter and serious spillover threats ahead from Europe’s debt crisis, all feed this thesis. Fed policymakers from Chairman Ben Bernanke on down the line to Cleveland Fed President Sandra Pianalto and James Bullard of St. Louis have also stoked the market with a more dovish tone the last little while. And yet, this is probably not the time for a big policy move.

Topping the list of reasons to disappoint – and to knock the market down to size – the Fed probably doesn’t want to front-run the July employment report that’s due on Friday, and which will give a fresh sense whether the spring-summer slump in the labor market is temporary or more permanent. Waiting until the Fed’s next scheduled meeting, Sept. 12-13, would give policymakers the added benefit of the August jobs report. And speaking of front-running, the U.S. central bank may not want to get out just ahead of the European Central Bank’s policy decision on Thursday. If, down the line, things get really ugly in Europe – or if the U.S. Congress sends the country off the so-called fiscal cliff – the Fed will probably want to have the QE3 bazooka ready in its arsenal.