Sunday, September 26, 2010

Bernanke and QE2

by Bill McBride on 9/26/2010 06:15:00 PM

On August 27th, Fed Chairman Bernanke gave a speech at the Jackson Hole symposium that might be worth reviewing. Note: I posted an analysis of the speech in August: Analysis: Bernanke paves the way to QE2

Although Bernanke pretty much stuck to the official forecast in his speech: "Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place", he also outlined the requirements for further Fed policy action:

Under what conditions would the FOMC make further use of these or related policy tools? At this juncture, the Committee has not agreed on specific criteria or triggers for further action, but I can make two general observations.

First, the FOMC will strongly resist deviations from price stability in the downward direction. ... It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
Now fast forward to the recent FOMC statement (see Sept 21 FOMC statement and Paving the way for QE2):
"Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."
...
[The FOMC] "is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate."
Remember, on August 27th, Bernanke said the FOMC would "strongly resist deviations from price stability in the downward direction". The above change to the FOMC strongly suggests additional policy action is coming.

Also - the FOMC and staff forecasts will be presented this coming month, and these forecasts will probably be revised down again. That will probably meet the "significant weakening of the outlook" criteria.

In Bernanke's Jackson Hole speech he made his preference clear if the FOMC decided on additional monetary accommodation:
A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed's earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC's recent decision to stabilize the Federal Reserve's securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.
And what does Bernanke think this will accomplish?
The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
This probably pushes some investors into other assets as well, and historically quantitative easing has led to increases in asset prices in the short term. This is why I've been noting in the comments that "bad economic news" is perhaps "good stock market news" - since investors are now anticipating QE2 to be announced as early as November 3rd barring a sudden improvement in the news flow.

Although there will be plenty of economic data between now and the two day meeting on November 2nd and 3rd, the two key releases are the September employment report (to be released on October 8th) and the Q3 GDP advance estimate (to be released on October 29th). Barring a significant upside surprise in one or both of those reports, it appears QE2 might arrive as early as November.

Note:
  • Summary for last Week ending Sept 25th (with plenty of graphs)
  • Weekly Schedule for coming week