More good news. Now what? | FT Alphaville

More good news. Now what?

It is less than a month away from the next FOMC meeting (September 12-13), and Bernanke’s speech at Jackson Hole is at the end of August.

Check this week’s posts at Calculated Risk or this series of charts from Joe Weisenthal for detail, but the short story is that quite a few economic indicators have outperformed expectations in the last couple of weeks.

Payrolls, the trade deficit, the Fed senior loan officer survey, retail sales, homebuilder confidence, and industrial production all came out better for July than had been anticipated. And all the while it increasingly appears that housing has finally bottomed.

Of course there are exceptions, and the unemployment rate remains stuck at 8.3 per cent. But the recent trend has been enough for some analysts and economists to begin suggesting that QE3 may not happen in September.

And as SoberLook writes, conditions now are different from what they were leading up to the first two rounds of QE. The first round sent the message that the Fed wouldn’t let the financial system collapse, and the second that it would do all it could to prevent outright deflation. Annualised headline PCE in the second quarter of 2010 was just 0.6 per cent, and Jackson Hole had been preceded by a string of terrible payrolls reports. The two editions of Operation Twist also seemed partly geared at targeting the unique problems in the housing market and perhaps to avoid the impression that the Fed was passively tightening policy by doing nothing.

We’re less sure that this means QE is unlikely. The possibility remains that Europe will again flare up once vacation is over, and the risks from the fiscal cliff are unchanged. With inflation seemingly having rolled over in recent months with the decline in commodity prices, the argument can be easily made that the Fed is currently undershooting its inflation target while (as is all too plain) continuing to also dramatically miss on the unemployment side of its mandate. And we wonder if Williams and Rosengren would be openly talking about an open-ended purchase program if some kind of QE were no longer on the table.

Who knows. Whatever the case, recently analysts and economists have been raising their GDP tracking estimates for the third quarter.

Now, a quick look at the annual revisions by the BEA reveals that these estimates are mostly nonsense. Take a look at the dramatic downward revisions for the first half of 2010, for example, and then explain how it is possible to reasonably estimate GDP in real time with any precision.

But the direction of their change at least gives a sense of how economists currently assess what’s happening. So with the necessary caveats aside, here are excerpts from a Goldman Sachs note this morning that predicts the Fed will actually stand pat in September:

Our Q3 GDP tracking estimate edged up to 2.3%. …

The recent news on the pace of the recovery also has implications for Federal Reserve policy. To be clear, our own view remains that there is a very solid case for additional accommodation under the Fed’s dual mandate of maximum employment and 2% inflation. And we do believe that Fed officials will ultimately decide to ease policy further.

However, in contrast to a number of other forecasters, we do not expect a move to QE3 at the September 12-13 FOMC meeting. Although Fed officials clearly adopted a strong easing bias at the July 31-August 1 FOMC meeting, we do not think that this amounts to a pre-commitment to QE3. Instead, we believe that continued weakness is necessary to prompt a substantial easing move. And so far, that weakness is not showing up in the data. Among the top-tier indicators released since the meeting, only the July ISM manufacturing index was a (modest) disappointment. In contrast, the July employment report was at worst a split verdict, the July nonmanufacturing ISM was a bit better than expected, jobless claims have surprised on the low side over the past few weeks, the June trade deficit showed an unexpected decline, and the July retail sales report surprised on the upside.

Other factors have also, at the margin, swung against the expectation of aggressive near-term easing. The inflation outlook has become a bit cloudier in the wake of the recent recovery in commodity prices; while Tuesday’s upside surprise on producer prices was largely driven by volatile sectors such as vehicles and tobacco, underlying price pressures were also a touch firmer than we had expected. Moreover, our GS financial conditions index has now fully unwound the tightening seen in the second quarter, and we have found previously that the meeting-by-meeting probability of Fed easing is quite sensitive to financial conditions.

To be sure, the uncertainty around the near-term trajectory of Fed policy remains substantial. Several FOMC meeting participants, specifically Presidents Evans, Rosengren, and Williams, are making the case for additional easing via potentially open-ended balance sheet expansion. And it might well be that Chairman Bernanke will use his speech at the upcoming Jackson Hole Symposium to explain why the Fed’s mandate calls for further accommodation in the near term. We will be receptive to these messages and will review our monetary policy forecasts as needed. But our call remains that the return to QE will not happen until late 2012/early 2013, and at the margin the recent data have made us a bit more confident.

Related link:
An early FOMC preview: the menu of options – FT Alphaville