QEII QED

The US dollar chopped around in the immediate post-Fed markets. Although weaker the dollar did not break down in Asia (except against the New Zealand dollar on the back of a strong employment report), but it has been sold off hard in Asia.

Risk assets--equities, commodities are in demand and bonds, especially in Europe have been sold off. The European debt woes are eivdent as premiums over Germany continue to widen. Ireland and Portugal are under the most pressure. It is notworthy that while China says it may buy Greek and Portuguese bonds, Russia says that its oil wealth fund will exclude Irish and Spanish bonds.

The Fed’s QEII, well telegraphed, has been broadly criticized by luminary economists like Mundell and Stiglitz, as well as policy makers in emerging markets in Asia and Latam. There was a choppy initial response to the Fed’s announcement in North America and Asia did not do much either, but in Europe the dollar has been sold off hard. The euro’s high this year was set in mid-Jan near $1.4580 and increasingly this is what momentum players are talking about.

The Fed’s signaling channel worked well and while the amount $600 bln is 20% more than consensus, the period is stretched out a bit longer and the average monthly purchase is, if anything on the low end of expectations.

Nevertheless two aspects of the QEII announcement have captured the attention of participants. First, there is the open-ended nature of the FOMC commitment. The Fed seemed to emphasize the binding nature of its commitment to its dual mandate for price stability and full employment. It is not a question of policy preferences, but a legal mandate. Without specifying how much progress toward reaching those objectives, it is not clear what terminates the policy.

Second, the amount of Treasury purchases between the QEII and the recycling of mortgage bond holding maturities, the Federal Reserve is committed to essentially buying the complete new net issuance in the coming months. Although the Fed’s signaling and market expectations would have led to this conclusion, many seem surprised. What is less commented on, but what seems remarkable is that most high income countries would welcome the Fed’s base line GDP and inflation forecasts for their own economies, but for the Fed it is not good enough.

No government can target the currency level, inflation, economic growth, and maintain a commitment to open capital markets. The Fed's mandate requires it to use interest rates to promote growth (full employment) and inflation (price stability). It uses interest rates and now QE to achieve it. Many other countries, never fully accepting floating exchange rates prefer using their curency to achieve domestic policy goals.

Lastly, Trichet's press conference may be of interest, but the key decision, when to exit the fixed rate unlimited amount refi operations and make banks bid a fixed amount of funds, is more likely next month.