When the Inevitable is Evitable

In recent weeks, the market had appeared to be scaling back expectations of another round of asset purchases by the Federal Reserve.   US 10-year Treasury yields rose nearly 40 bp since the August 1.  The reconsideration was spurred by a single word:  Data.

Consider what investors and policy makers have learned since the FOMC last meeting concluded on August 1.  Private sector non-farm payrolls posted their strongest growth since February.  The four-week moving average of weekly initial jobless claims has fallen back to levels last seen in March.  Consumption increased, as retail sales (roughly 40% of personal consumption expenditures) rose by the most since February.  Industrial output and manufacturing continue to expand (the latter increased at an annual pace of more than 6% in June-July).  Consumer confidence has increased and forward looking data suggest the economy is accelerated as Q3 got under way.

Yet the minutes from the FOMC meeting triggered another about face.  The key take away from the minutes that has prompted a number of economists to proclaim the inevitability of QE3 can largely be found in a single sentence:  "Many members judged that additional monetary accommodation would likely be warranted fairly soon..."   Quite convincing, no?

No, because the modifying clause was de-emphasized, if not ignored: "...unless incoming information point to a substantial and sustainable strengthening in the pace of economic recovery."  

While one month's jobs report may not pass muster, a second one might.   As we suggested, August non-farm payrolls seems to be the key and our early call is for the private sector job growth to match the July gain of 172k.  If this does materialize the 2-month average will nearly double from what the FOMC was looking at on August 1.  Growth in Q3 appears to be recovering from the 1.5% in Q2 to something somewhat north of 2%.  

This would seem substantial, but the judgment may rest on whether it is sustainable.  It is difficult to envision any high frequency data that sheds convincing light on the sustainability of economic activity.   High frequency data, which is all that will be available to the FOMC, are by definition volatile.   

Methodologically, we take seriously the Fed's staff forecasts.  What ultimately matters for Fed policy is not the economic data in and of itself, but relative to expectations.  The expectations that are key are not the market's consensus, despite the criticism that the Fed follows the market too much, but the Fed's own expectations.  

New staff forecasts will be presented in the September meeting. The midpoint of its 2012 GDP forecast is for 2.15% growth.  Even assuming some pick-up in H2, which the Fed seems to assume, this year's GDP forecast will likely be shaved to maybe just below 2%, just to recognize the weakness in H1.  Next year's GDP is expected to increase to 2.5%.  

It is an interesting forecast at this late date.  It is implicitly making some assumptions about the fiscal cliff.  The CBO updated its budget forecasts and projects that should the fiscal cliff not be avoided, the economy will contract by 0.5% in 2013.  

If the FOMC adopts a new round of asset purchases in September, what will they do if the fiscal cliff is hit and the economy falls into recession year?  

The Fed's policy response needs to be commensurate with the risks.  The economy has under-performed FOMC expectations and this warrants a policy response.  Future guidance, such as shifting the time that rates will be low from late 2014 into 2015, seems the most likely response.  

There seems to be some appreciation that the challenge is not simply driving down interest rates.  The moderate growth and price pressures, and the safe haven role of Treasuries have in fact lowered rates not just for the government, but also for businesses and mortgages.  However, the problem of accessibility to credit remains more intractable.   

Officials are watching the European "experiment" of cutting the interest it pays on excess reserves to zero, and the UK's funding for lending scheme, they do not seem  prepared to follow either at this juncture.  However, some guidance from Bernanke or the FOMC that  the Fed is exploring alternative measures to enhance the accessibility of credit if the banks can't or won't, may help prepare investors for something other than asset purchases.  

Many observers seem a bit schizophrenic about the asset purchases.  Many economist say that asset purchases have minimal impact at best and yet they expect the Fed to continue to pursue it.  Here too the Fed's assessment is more critical.  The minutes showed that "many" (which we take to mean a near majority) of the FOMC believe that additional asset purchases could provide additional support for the economy and the staff suggests that there is still a large capacity to absorb additional Fed purchases.  

During the crisis response thus far, the FOMC has not changed guidance and announced asset purchases at the same meeting.  The next FOMC meeting after the Sept 12-13 date is in late Oct (Oct 23-24), which seems too close to the national election; meaning that the bar to action may be higher than is normally the case.  

In some ways, the market read the FOMC minutes in a way that allows it to do what it wanted to do before the fact.  Speculators were already reducing long dollar exposure and reducing short bond futures positions.  Both moves likely have more room to run ahead of Bernanke's speech at Jackson Hole at the end of next week.  

What seems to some as so inevitable today may seem decidedly less so in two weeks time if the jobs data looks for like July than June.  Lastly, we note that the dollar has tended to appreciate after asset purchases are announced and other countries that have pursued quantitative easing have not seen their currencies depreciate.  We continue to suspect that while US challenges are important, Europe's remain urgent.