Ahead of next week’s FOMC meeting, and as the G20 tries to preemptively assuage global markets with the kind of enthusiastically meaningless statements in which it specialises…
Since the last FOMC meeting we’ve had two disappointing US payroll reports, declining measures of inflation and inflation expectations, worries that growth in emerging markets has slowed more than anticipated, and Europe… well, how much time have you got?
More generally, as our colleague Robin Harding wrote last week, this summer increasingly resembles the last. Next week we’ll find out what the Fed plans to do about it:
If the Fed does choose to act then its main options are switching more of its existing investments into long-term securities, a so-called Operation Twist 2 – which is feasible and low risk but limited in capacity – or it could buy more assets outright, most likely mortgage-backed securities, in a QE3.
With Spain teetering on the precipice and the outcome of the Greek elections this weekend uncertain, quite a lot can happen in the short time between now and next Wednesday’s statement and presser.
It’s not possible now, in other words, to predict the outcome of next week’s meeting with any precision (to the extent that it’s ever possible). So consider the two items below with that in mind.
First up, a decision tree from Credit Suisse (which inspired the obnoxious headline):
We put the chances of an easing move at approximately 80% that day – an extension of Operation Twist (60%), a new large scale asset purchaseprogram or “QE3” (15%) and other actions (5%).
Operation Twist extension – This option would be balance sheet neutral and, as a consequence, invite less criticism from those uncomfortable with the potential inflationary ramifications of further expanding the volume of bank reserves (and the monetary base).
Research conducted by our US Interest Rate Strategy team suggests that the FOMC ca nextend Operation Twist by $300bn ($50bn/month through year-end) by selling short-termTreasuries up to and including part of the four-year maturity sector. Purchases in this extended Twist operation may include Treasuries (perhaps $100bn) and MBS ($200bn). Such a structure would help support housing while furthering the Fed’s stated goal of reducing market risk premiums.
Quantitative Easing – This option would further increase the Fed’s $2.9 trillion balance sheet. A third round of outright asset purchases (QE) is so contentious within the FOMC and the broader political environment, that the Committee will likely avoid such a move unless economic or market conditions deteriorate markedly from this point.
Other options – We have included in this catch-all category steps the FOMC conceivably can take, but probably will not. These include cutting the interest paid on bank reservesfrom 0.25% to zero; cutting the discount rate to 0.50% from 0.75%; extending the forward guidance on exceptionally low rates from “at least through late 2014” until sometime later; and cutting the price charged to foreign central banks for tapping the dollar-liquidity swaplines from 50bp over OIS to a spread of 25bp. Also included in this category are more innovative forms of easing such as specifying a fixed duration for the Fed’s securities portfolio.
Second from Nomura economists, some longer commentary and a big comparison chart:
The expected intensification of the eurozone crisis will likely magnify the downside risks to the global economy. The Minutes of the April FOMC meeting made clear that the FOMC stands ready to adopt additional accommodative measures if such downside risks become large enough. We think this is now likely. The Fed’s response to this type of threat could include many of the tools it has used in recent years.
The most likely response would be additional Large Scale Asset Purchases (LSAPs). In the program now commonly known as QE-II, the Federal Reserve undertook an intentional further expansion of its balance sheet by purchasing long-term securities. In addition to their direct effect on banking system reserves, these LSAPs also induce a rebalancing of portfolios by private sector investors (who sell securities to the Fed). In response to either a marked deterioration of domestic economic conditions – or the rising risk that such a deterioration would likely occur owing to the deteriorating situation in Europe – the FOMC is likely to launch another regimen of LSAPs, relying on the resulting portfolio rebalancing by private investors to provide some “easing” of financial conditions. …
Either as an alternative or as a complement to a new round of LSAPs, the FOMC might also signal an intention to change the composition of its securities holdings. This might entail a shift in the maturity structure of its securities portfolio – i.e., an extension of “Operation Twist” — or in the credit risk profile of its holdings. However, the Federal Reserve Act limits the securities the Fed can buy to only those that are explicitly backed by governments. In principle, this would not preclude Federal Reserve investment in foreign sovereign debt but it seems unlikely that the FOMC would risk antagonizing its own overseers – i.e., Congress – by embarking on such a course.
Lastly, the FOMC might also opt once again to attempt to alter market expectations by communicating an intention to maintain a highly accommodative stance well beyond the current “late 2014” expectation. Of course, the FOMC has used, with varying degrees of success, all of these “unconventional” policy tools. Although their effectiveness in the past remains a matter of controversy, these tactics remain, from the perspective of policymakers themselves, critically important options to be deployed if conditions warrant.
Recent statements by Federal Reserve officials do not suggest that they are inclined to change policy at the next meeting on 19-20 June. Given that “Operation Twist” is scheduled to end soon it can be argued that the FOMC needs to extend the program to avoid the appearance of a tightening of policy. But the predominant view among Federal Reserve officials is that the primary impact of its LSAP programs comes when they are announced, not as they are implemented. In this view simply allowing Twist to end on schedule should not be viewed as a tightening of policy.
Of course an alternative view – that the actual transactions matter – cannot be rejected with certainty. With the market’s heightened concerns about the course of policy the FOMC may wish to avoid any impression that they intend to tighten policy and therefore may choose to extend Operation Twist for some period of time out of an abundance of caution.
By the way… Despite the myriad research notes from the private sector and the extended discussion here and elsewhere about the merits of sterilised QE, we’re overdue in mentioning that Jon Hilsenrath’s article in March was likely wrong.
In addition to Robin’s report that sterilisation wasn’t being considered, it hasn’t been mentioned in the minutes of the two FOMC meetings since. How likely is it that this is being seriously debated given that it didn’t even warrant a single line? Doesn’t mean it’s a bad idea or that it won’t emerge one day as a real possibility, but it isn’t one now.