1. Since the second phase of Operation Twist just got underway, “it would be strange to announce outright purchases of Treasury securities.” 2. Fed officials have publicly noted that continued purchases of long-term Treasury securities “might compromise the functioning of the Treasury market — and undermine the intended effects of the policy.” 3. San Francisco Fed President John Williams “directly advocated” mortgage purchases and Fed Vice Chair Janet Yellen has said that “beyond the Twist extension, ‘it’s more likely that [the FOMC] would do things that would take a different form.’” 4. “Purchases of mortgage-backed securities may be considered less controversial than Treasury bond purchases amidst the charged political environment, just prior to the presidential election.”
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.
Federal Reserve Chairman Ben Bernanke “might have something up his sleeve next week” when he delivers his semi-annual monetary policy report to Congress: he could hint at a “funding for lending” program similar to what the Bank of England announced last month, according to one long-time Fed watcher.
If the Fed wants to ease again, the first lever they pull might not be more quantitative easing where the Fed buys government bonds to help keep interest rates low in the hope that low rates will foster lending and economic growth, says Decision Economics economist Cary Leahey.
Bernanke is scheduled to testify before the Senate Banking Committee on Tuesday and in front of the House Financial Services Committee on Wednesday.
So much for policy coordination. Just days after the Treasury published a note touting its progress in lengthening the average maturity of its outstanding bonds, the Fed decided to extend Operation Twist – a policy aimed at doing the exact opposite. By selling an additional $267 billion in short-dated bonds to buy long-term ones, the Fed is trying to take Treasuries with longer maturities out of the market, to lower yields and entice investors to take on more risk.
In a narrow sense, the Treasury’s approach is perfectly reasonable: U.S. interest rates are at historic lows, so it stands to reason that the government should lock in that low cost of borrowing for the longest period possible. However, in the context of an economy that remains exceedingly weak – and where the only source of stimulus appears to be a reluctant central bank – the move could be viewed as somewhat incongruous.
Fed Chairman Ben Bernanke himself addressed the issue when he was asked during the post-meeting press conference whether it would make sense for the U.S. government to issue more longer-term bonds given the current low-rate environment.
The Bank of England is finally catching a break. With Britain’s economy officially in recession, the BoE had been constrained from further monetary easing by a stubbornly high inflation rate. But as the global economy stumbles and Europe’s crisis rages unabated, UK price pressures may be giving way.
Barclays economist Chris Crowe argues:
We expect the MPC to announce an additional £50bn in QE at the July policy meeting.
CPI inflation fell to 2.8% y/y in May (Barclays 3.1%, consensus 3.0%) from 3.0% in April. Meanwhile, RPI inflation declined to 3.1% y/y (Barclays and consensus 3.3%), from 3.5%. With near-term inflationary pressures easing, the case for additional QE in response to faltering confidence is stronger.
Ben Bernanke appears to be reluctantly gearing up for a third round of large-scale Federal Reserve bond buying, so-called QE3. Millan Mulraine of TD Securities captures just how likely further monetary easing is becoming following the Fed’s decision on Wednesday to expand Operation Twist.
The burden of proof may now be on the incoming data to prove that a third round of large-scale asset purchases may not be necessary.
Just under two months before the central bank’s yearly gathering at Jackson Hole – where Bernanke announced QE2 – the Chairman emphasized the path of the job market will be a key driver of any decision to further expand the central bank’s $2.8 trillion balance sheet. He told reporters at a press conference:
Additional reporting by Ann Saphir. Updated with New York Fed and other details.
For a central bank that prides itself on transparency, the Federal Reserve remains cautious about adopting new ways of communicating its message. The Fed’s Washington-based board was a latecomer to Twitter. Its first tweet was dated March 14, well after its regional Fed counterparts.
Perhaps more tellingly, the @FederalReserve account follows most – but not all – regional Fed accounts. Of the 12 district banks, only the two most hawkish (and therefore likely to oppose the Fed’s unconventional monetary policy) are missing: Richmond and Kansas City. The third is New York, whose heavy influence on financial markets sometimes puts it at odds with the board. In fairness, the board does follow the Dallas and Philadelphia Feds. Its presidents, Richard Fisher and Charles Plosser, have also criticized Fed purchases of government and mortgage bonds, known as quantitative easing or QE.
Are politicians playing chicken with central bankers? More to the point, if the U.S. Federal Reserve or the European Central Bank step up, yet again, to protect their economies from the global slowdown, will it take U.S., German, Spanish, Italian, Greek and other governments off the hook?
Such questions are swirling as Europe’s financial crisis boils and starts to bubble over into Asia and the Americas. Expectations are growing that the Fed will take more monetary policy action when it meets June 19-20. The messy possibility that Greece could exit the euro zone was not enough to prompt the ECB to cut interest rates last week – and that was before a deal over the weekend to bail out Spanish banks was dismissed by markets as just another kick of the can. Underlining the standoff between monetary and fiscal policymakers, ECB President Mario Draghi told European Parliament this on May 31:
Can the ECB fill the vacuum of lack of action by national governments on fiscal growth? The answer is no.
Seemingly lost in the talk about whether or not the Federal Reserve should ease again is the idea that financial conditions have tightened and the U.S. central bank may have to offer additional stimulus if only to offset that tightening. Writes Goldman Sachs economist Jan Hatzius:
Alongside the slowdown in the real economy, financial conditions have tightened. Our revamped GS Financial Conditions Index has climbed by nearly 50 basis points since March, as credit spreads have widened, equity prices have fallen, and the U.S. dollar has appreciated.
Goldman’s new GS Financial Conditions Index is based on the firm’s simulations with a modified version of the Fed’s FRB/US Model. It includes credit spreads and housing prices and has a closer relationship with subsequent GDP growth than the previous version of the index, the firm says. A 100-basis-point shock to the GSFCI shaves 1-1/5 percent from real GDP growth over the following year. Still, it’s not quite as bad as it sounds:
Chris Reese contributed to this post.
A barrage of rotten economic news around the world has suddenly and vigorously reawakened the prospect of additional monetary easing by the Federal Reserve – most notably a report on Friday showing job growth slowed sharply in recent months.
William Larkin, portfolio manager at Cabot Money Management in Salem, Mass., said:
The chance of another recession is on the table, no question about it. It might force the Fed to develop another growth strategy like a QE3.