Setting the stage for QE III?
Despite dissension and many legitimate questions about the efficacy of continued non-standard monetary policy tools the Fed is, in our view, very likely to seek additional tools to stimulate growth. They are not, however, likely to engage in additional Large Scale Asset Purchases (LSAP) or quantitative easing as the market calls it unless we see a default in Europe that requires massive liquidity pumping in the global system. The end of Tuesday’s FOMC statement gives us a clue to further policy action: “The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.”
The three voting members who dissented, Richard Fisher from the Dallas Fed, Narayana Kocherlakota from the Minneapolis Fed, and Charles I. Plosser from the Philadelphia Fed have telegraphed their concerns over the current accommodative policy stance but this is the first time they have voted against Chairman Bernanke. I noted in my April 15, 2011 piece on the FOMC that these three were likely to be dissenters if monetary policy remained loose or if additional non-standard measures were used. Even though the district that is covered by the Dallas Federal Reserve Bank (Texas, Northern Louisiana and Southern New Mexico) is relatively strong with Texas boosted by strong oil prices, the Dallas Federal Reserve Manufacturing survey is showing signs of faltering strength. Meanwhile, the Philly Fed Index has decidedly fallen from its highs. While, in the 9th district where the Minneapolis Federal Reserve and Narayana Kocherlakota sit, the situation is comparatively pretty good. Throughout the recession and recovery period the 9th district has benefited from the relatively strong farm economy as well as energy and mining. Likewise, services and manufacturing in the district seem to be doing better than their national peers. Even with some softening in their districts, the three dissenters are all situated in regions of the U.S. that are experiencing relative strength and inflation pressures. This gives them reason to believe that the economy is on a more solid trajectory than say, Dennis Lockhart from the Atlanta Fed. Still what we find curious is that price data in most regions is showing signs of moderating. Current inflation levels will prove to be a false signal come the 4th quarter.
Exhibit 1: Prices Paid (Diffusion index, SA, %):
Philly Fed Business Outlook (Red)
Dallas Fed Manufacturing Survey (Black)
Sources: Philly Fed, Dallas Fed/Haver Analytics
The Federal Reserve will continue to debate non-standard measures as it said in its statement and we expect the market may get out over its skis in terms of expectations from Jackson Hole. While we do believe continued weakness in the U.S. economy will result in continued non-standard measures, we believe the big guns will be kept in reserve for a meltdown in Europe. We have long believed that if Europe were to experience significant difficulties it would so rile financial markets and liquidity that the Fed would probably need to step in, even if only to engineer another equity market rally. It is not uncommon for a so-called perfect storm to develop in financial markets and with the downgrade of the U.S. by S&P, the faltering of Europe’s continued effort at rescuing its periphery, and the spread of the crisis to core countries such as Italy and now even France such a perfect storm seems to be brewing. The question is what, if anything, will the Fed do about it?
Our view remains that it will require an event in Europe, perhaps an acceleration of the slow moving train wreck we have seen so far. The difficulty is that a default event in Europe appears to be coinciding with events (both economic and political) in the U.S. The S&P has gone from 1200 on August 4th to 1173 on August 11th, extending a downturn that was already taking place. As I update this piece, the S&P is now back above 1200. In speaking with our contacts at the Fed and reading the tea leaves in the statement, we get the sense that the Fed will not be able to assuage dissenters unless price pressures ease. But an easing of price pressures, perhaps the return of disinflation, will certainly follow a write-down of European debt. So far, the rout in markets has also been accompanied by a fall in oil prices with Brent falling from $127 to $108 per barrel last Friday, a 15% drop. Normally a fall in oil prices would give a helping hand to economic growth, but with a potential European default on the horizon we fear that the fall in oil price will not be the good news it normally is. Instead we watch and wait for the catalyst that will provide a decisive action in Europe; so far it feels we are waiting for Godot.
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