The Bang We Have Already; The Bucks Are Yet To Come
Not that there was any great suspense about whether the Fed would be considering the shape of the QE2 campaign at the FOMC meeting next week, but if further confirmation was needed it came today in the form of news that the Fed asked dealers for their estimates of the size and time to complete of large-scale asset purchases (LSAP, or QE2) over the next six months along with the question of what the effect on yields may be. I have been on some of these calls in the past, and what the Fed usually asks is both “what is your firm expecting” and “what do you think other firms are expecting.” Bloomberg carries the story here.
The Fed probably only really cares about what one or two of its favorite dealers think, but since estimates have ranged from zero to $1-2trillion over all sorts of different time frames, it is prudent of the central bankers to get a feel for where disappointment would actually set in.
I expect that the Fed will announce a program that is near its maximum capacity, generally supposed to be around $100bln per month. Given that they cannot go out and buy $500bln or $1trillion in a few weeks, I don’t really see much advantage to announcing the total amount in advance. If it were my decision (on implementation, that is; if it were my decision on whether to do it or not the answer would be “no”), I would say something like “The Federal Reserve has determined to purchase approximately $100bln in Treasury securities per month until such time as …” and insert a condition. The particular position, of course, is where the rubber meets the road, and it could be a price-target approach (“…the compounded inflation rate from September 2010 onward reaches 2%”), a growth-target approach (“…measures of resource utilization become more fully utilized”), or a subjective approach (“…the average forecasts of FOMC members for year-ahead core inflation exceeds 2%”).
These are all problematic in different ways, though. The weighty drag of the housing bubble unwind will ensure that even if ex-Shelter core inflation were to be running near 4%, the “core CPI” could still be around 2-2.5%. This makes the traditional inflation measures to be bad target variables, because normal shades of monetary policy have no chance to affect the price of shelter when there is a 4mm-unit overhang. (Of course, outrageous amounts of money-printing would cause home prices to rise, but with that level of monetization I doubt the Fed would be worrying much about quarters and eighths of a percent). The Fed can therefore target 2% core inflation, but that would implicitly be letting the inflation genie out of the bottle for the 2/3 of the economy that isn’t housing.
The Fed meeting is still several days away, but while there are still economic releases to come it seems quite unlikely that the Committee will be dissuaded from action simply because Initial Claims came in at 434k rather than 455k (the BLS said the drop was related to post-Columbus-Day seasonal adjustments), or in the event that the Advance Q3 GDP report due tomorrow (Consensus: +2.0%, +2.5% personal consumption, +1.0% core PCE) or the Chicago Purchasing Managers Report (Consensus: 58.0 from 60.4) shows more growth than expected, or if the Employment Cost Index (Consensus: +0.5%) suggests inflation higher than the Fed’s forecast.
The train has gone too far to be derailed now. Moreover, we should not forget that what is provoking this action is not the perverse weakness in the economy right now but the visibility we have about the fiscal drag that will hit in Q1: higher taxes, potentially much higher if Congress does nothing; moreover, if the Republicans hold serve then they are also pledging to cut spending as well. This latter is certainly a good thing for 2012 and beyond, but there is no doubting the impact it would have on growth in 2011. QE2 is being initiated because the central bank feels it cannot stand idly by while this boulder is rolling towards us. And that means there is no time to waste. It will happen at the November meeting.
As for the market impact, QE2 has already induced the main part of its impact on the rate structure (as long as the actual program isn’t vastly different from the $500bln or so that I believe the market is expecting). The chart below (Source: Enduring Investments) shows 10y inflation swap rates in the UK, US, and Europe.
You can see that since late August, US 10y inflation swaps have risen around 50bps (depending on the exact day you choose to count from). I choose August 27th, because that is the day that Bernanke delivered his speech at Jackson Hole. 10y US CPI swaps closed at 2.08% that day; today those swaps finished at 2.54% (the latest 2 days are not reflected on the chart). I show the inflation swaps because it seems very clear that the move was not echoed in the UK or European inflation markets. US rates moved from being closer to the European standard (the ECB to date is assumed to be more hawkish on inflation because of its Bundesbank DNA, although I have my doubts how long that can hold) towards the regime where quantitative easing is already a reality.
The flip side of the coin is that 10y real rates (not shown) have fallen from 1.01% on August 27th to 0.51% today.
People who are fixated on nominal rates (the poor, benighted souls) might believe that the market could move substantially lower in yield once QE2 is announced. Nominal rates are, after all, net unchanged since August 27th (actually, +1bp). But clearly, there have been significant moves in rates, and in particular real rates have done exactly what the Fed wants them to do, and in a significant way. It strikes me as hard to believe that real rates can fall another 50bps without a truly massive program, and it seems unlikely that QE2 will lower inflation expectations, so I think we’ve already gotten essentially all the bang for our buck that we’re going to get.
The only thing left to see, as my good friend Marty said it yesterday, is whether the bullet once fired is destined to hit a bad guy…or a good guy.