The Fed cometh like a thief in the night

Posted by Joseph Cotterill on Sep 23 17:05. 4 comments | Share

It’s increasingly not if, but when, as far the market is concerned over the Federal Reserve’s most recent pronouncements on reviving quantitative easing.(QE2)

But when is when? And what might answering that tell us about inflation?

Morgan Stanley’s monetary analysts — long-time inflation contrarians — had a helpful if cautious guide to the first question on Thursday:

Renewal of asset purchases unlikely, but it’s a close call:
We believe that the incoming growth data will be sufficiently positive to prevent the reintroduction of asset purchases in coming months. Indeed, since September 1, our tracking estimate for 3Q GDP has risen from +1.7% to +2.6%. But it’s a close call, and the FOMC could act at any time if the data disappoint. So, some analysis of an asset purchase programme seems warranted. Here is a brief Q&A:

Q) What is the trigger for renewed asset purchases?
A) This is a tricky one to answer because it’s the assessment of tail risk (not the baseline forecast) that really matters. If Fed officials perceive a significant probability that recovery is stalling out, then they have to do something. To be more specific, we suspect that a perception of a one-third or higher probability that GDP growth will slip below the +2% ‘escape velocity’ pace for a few quarters would trigger another round of asset purchases.

Q) What is the timing?
A) Could happen at any time (on an FOMC meeting day or even between meetings) since it is data-dependent. In particular, we do not believe that the timing of the November FOMC announcement (the day after the mid-term elections) has any bearing on the likelihood of a move at that time.

Credit Suisse also reckon asset purchases are unlikely this year, but have pencilled in a possible December date for QE2 at the earliest, arguing that action before then would be too politically sensitive. But again, it’s all a bit uncertain, helping to explain why bond yields are staying low:

They’re staying bullish on equities (especially ones which ‘proxy’ inflation, such as utilities, but avoiding life insurers exposed to low bond yields) and gold as a hedge on QE failing. As they explain:

We believe the bond market is telling us that central banks are likely to be very dovish 鴿派的; 主和的 and that if necessary governments could force central banks to keep real rates abnormally low in order to alleviate the debt burdens (a form of financial repression that can be achieved by changing the central banks’ charters or raising their inflation targets). We stress that, unlike in 2008, the fall in bond yields since early April (-124bp) has been much more about the fall in real bond yields (-76bp) than the fall in inflation expectations (-48bp)…

Well — interesting sidelight here, in fact. Inflation expectations are indeed reviving somewhat.

Here’s a chart showing the spread between five-year forward US inflation break-even rate and five-year Tips, for example:

And in relation to that spread — we’d note the following from James Hamilton, over at Econbrowser (emphasis ours):

One option for the Fed… is to signal what it intends to do a few years down the road, when interest rates rise off the zero lower bound and the Fed resumes its usual powers. If the public is persuaded today that the future Fed will be more expansionary once we return to that regime, such a perception potentially could help stimulate spending today…

Suppose you took that view… How would you interpret the following passage from Tuesday’s FOMC release?

‘Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.’

The most natural interpretation of those words is that the Fed is aiming at a long-run inflation target that’s higher than what we’ve been seeing lately. By its nature, that is a statement about what the Fed will be doing several years down the road, not a signal of something it’s going to do in November.

Ben Bernanke — time-traveller.

Related links:
The loneliness of the long-distance inflationista – FT Alphaville
Bullet cases on the floor, blades whirring in the distance – FT Alphaville
Central banks are depressing (yields) – FT Alphaville
Quantitative leap - FT Alphaville