Goldman’s Q(E3)&A | FT Alphaville

Goldman’s Q(E3)&A

There was no press conference with Ben Bernanke after the August 9 FOMC statement or following his Jackson Hole speech — and there won’t be another until after Congress pays attention and starts pulling its weight around here November 2.

But don’t fret, economists at Goldman Sachs are taking questions.

In a note out early Tuesday, they run through a quick Q&A on what the Fed can, should and will do at its two-day FOMC meeting in September.

We’d counsel against reading too much into the extension of that meeting to two days from one. It probably reflects a lack of clarity about what to do next, given the three dissenters at the last meeting, rather than the need for more plotting time.

The short version of Goldman’s take is that it forecasts a version of Operation Twist “a bit later” than the next meeting. The longer version is below, with our emphasis throughout:

Q: Will Fed officials ease monetary policy further?

A: Yes, we think so. At this point, we believe that the majority of the FOMC expects real GDP growth of around 2.5% in the second half of 2011, and perhaps 3% in 2012. As a result of growth that averages a bit above trend through the end of next year, the committee “…anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.” Our own expectation is that real GDP growth will average nearly 1 percentage point below the committee’s likely forecast and that the unemployment rate will go sideways to slightly higher. If we are right and the committee ultimately reduces its growth and employment forecast accordingly, we think that this shift in view will be accompanied by further monetary easing.

Q: Should Fed officials ease monetary policy further?

A: Yes, we think so.

There are two main arguments against further easing, but we don’t find them very compelling. The first is that “QE2 didn’t work, so why should QE3 be any better?” We disagree with the view that QE2 didn’t work. It is true that QE2 failed to ignite a more powerful recovery. However, we would attribute this to the combination of an even more adverse “baseline” pace of growth than we (and the Fed) had expected, and to the increase in oil prices. Moreover, our commodity strategists believe that most of the increase in oil prices was due to the tightening demand/supply situation in the oil market, exacerbated by the turmoil in the Middle East. Our belief that the moves in oil prices have been mainly driven by supply and demand rather than monetary policy is also consistent with the easing in oil prices over the past few weeks–a period in which the economic indicators have deteriorated and expectations of QE3 have grown.

The second argument against further easing is that most of the problems in the economy are not easily addressed by monetary policy but require either fiscal solutions or simply time. We agree that monetary policy is unlikely to be very powerful, but we do think that it would add a few tenths to GDP growth and would not have significant costs in terms of inflation given the large amount of slack in the economy (see “How Much Growth Boost to Expect from QE3?” US Daily, August 24, 2011). Ultimately, the question whether to ease is a cost-benefit calculation, and the benefits exceed the costs in our view.

Q: If it happens, what form will the easing take?

A: In his recent monetary policy testimony, Chairman Bernanke noted three ways of providing additional stimulus: (1) more explicit guidance about future policy, (2) changes in the size or composition of the Fed balance sheet, and (3) a cut in the interest rate on excess reserves (IOER) from its current 25 basis points (bp).

By stating their expectation that the funds rate will stay exceptionally low until at least mid-2013, Fed officials have already gone as far as they are likely to go with respect to (1). Moreover, while a cut in the IOER as per (3) is possible, it is unlikely to have a sizable effect given that the effective funds rate is only 8-9bp at present. This leaves (2) as the most straightforward option. Specifically, our current baseline expectation is a renewed asset purchase program that removes a similar amount of duration from the marketplace as the QE2 program announced last November.

Q: What assets would they buy?

A: Probably mostly longer-duration Treasuries. To be sure, the recent widening in agency MBS spreads has somewhat raised the probability that Fed officials might go back into that market, and a further widening could raise it further. It is also possible that MBS would be incorporated into a possible “twist” via sales of high-coupon securities (which have relatively short duration because of a higher probability of refinancing/prepayments) and purchases of low-coupon securities (which have relatively long duration). However, we think the hurdle against duration extension in the MBS market is relatively high because Fed officials remain determined to return to an all-Treasury balance sheet in the longer term. An increase in the stock of low-coupon securities that may not roll off the balance sheet for up to 30 years would make this process even more challenging.

Q: Does the Fed have more extreme options up its sleeve?

A: Yes, but the hurdles are very high, and a more radical approach is unlikely unless the economy and/or the financial markets perform substantially worse than we are forecasting. There are three main ways in which the Fed could be more radical: (1) an extension of the QE program into markets other than Treasuries and agency MBS, e.g., private sector securities, (2) a much bigger QE program, up to the extreme version of a promise to buy as many securities as needed to hit a specific yield target (i.e. a “rate cap” further out on the yield curve as then-Governor Bernanke suggested back in 2002), and (3) an explicit or implicit change in the Fed’s policy targets.

Finally, regarding (3), we have again received some questions about the possibility that the FOMC might move to a nominal GDP target (see “The Fed Discusses Easing Options,” US Daily, October 12, 2010, as well as this week’s Economics Focus in The Economist). It’s important to note that depending on the interpretation, the Fed’s dual mandate (in which policy responds to both employment/real GDP and inflation) already has some similarities with a nominal GDP target (in which policy responds to the product of real GDP and the price level). The key differences are that (1) an announced nominal GDP target is much simpler and therefore more powerful than the hazier dual mandate, which is interpreted differently by different people; and more importantly, (2) the dual mandate is defined in terms of rate of change of prices, while a nominal GDP target depends on the level of prices. (There is not such a clear distinction with respect to the employment/real GDP component, which is typically understood to refer to levels in the dual mandate definition as well.) The implication is that a nominal GDP target, Fed officials attempt to “make up” for past undershooting of inflation via future overshooting. In other words, a move to a nominal GDP target is tantamount to a temporary increase in the inflation target. We believe that the skepticism expressed by Chairman Bernanke’s in his 2010 Jackson Hole speech still applies, and do not expect a move to either a higher inflation target or a nominal GDP target.

Related links:
El-Erian: Interpreting Bernanke’s Jackson Hole speech – FT Alphaville
The Fed’s oil easing – FT Alphaville