My family's summer vacation has to be scheduled between the end
of my children’s summer camps and the start of school. With a
varsity athlete in the family, that window is very
short. And, as luck would have it, the American economy and
world markets always seem to be in turmoil during that interval.
I can't catch a break.
So, I'm filing this note from Door County, Wisconsin. It’s
an idyllic part of the Midwest: beautiful shores, quaint shops, and
grand sunsets. In a sign of the times, the local library has
become the most popular spot on the peninsula; I'm in a crowd of
people who are taking advantage of that rarest of Door County
commodities: wi-fi access. Pretty sad.
The Federal Open Market Committee will be meeting Tuesday and
Wednesday to decide on the future course of monetary policy.
Here is a matrix that looks at the pros and cons of the most likely
outcomes, along the subject lines that the Committee will likely
discuss.
QE III
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Stand Pat
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US economic activity seems to be faltering. Real GDP grew
at an annual pace of just 1.5% in the second quarter, well
below potential (which the Fed’s long-term forecast suggests
is around 2.5% in the current environment). Job creation has
diminished, and broad measures of unemployment have gotten
worse. Retail sales have softened. Analysts suggest rising
risk of recession. The time to use dry powder is now.
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Real GDP growth of around 2.2% for the past four quarters
is not a dire outcome. Further, we are in a classic
liquidity trap. Large fractions of past monetary easing
remain parked as excess reserves with the Fed. Borrower
surveys suggest that demand for credit is very modest, and
supply is limited by banks seeking to preserve capital.
Adding more accommodation would have the character of
pushing on a string.
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Inflation is at a modest level, and slower growth should
increase resource slack. Inflation expectations, as measured
by surveys and market indicators, remain well contained.
Should price pressure return, monetary policy can respond.
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M2 has been growing at a 10% annual pace. Some may
stop there in arguing against QE III. But to take one
step further, reversing quantitative easing will be a
complicated process that could be the subject of intense
political pressure.
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Additional large scale asset purchases would provide
direct aid to the housing market, which remains challenged
in spite of its recent gains. Lower mortgage rates
could boost sales or enhance refinancing, which would add to
spendable income.
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The housing sector can’t be saved with lower rates.
Normalized lending terms, limited mortgage markets, and a
host of policy uncertainties are conspiring to limit
progress. Spending gains from additional refinancing
would be small.
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What some describe as a fiscal cliff is actually a
mountain range. The Federal precipice is defined by
the coming expiration of stimulative elements and forced
sequestration. The other canyons are formed around
state and local budget valleys, which were carved from slow
growth in net revenue and heavy pension obligations.
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It isn’t practical or possible for the Federal Reserve to
compensate for all of the shortcomings of fiscal policy.
Attempting to do so would bring the Fed into closer
political range of its critics. Congress, once
reverential towards our central bank, has shown an
increasing willingness to meddle in monetary and regulatory
affairs.
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Events in Europe remain worrisome, despite the statements
of support from national and monetary leaders. The
Continent’s recession is hindering exports from the US and
from developing countries. The Continent’s banking
crisis is fomenting risk aversion and threatens contagion to
other markets. Another step from the Fed would have
fundamental and symbolic value.
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Most would agree that the Federal Reserve is not in a
position to solve Europe’s problems. Swap lines are in
place to mitigate potential cross-border liquidity problems
should they arise. Interestingly, the flight of
capital from risk assets into Treasury securities has
lowered long-term rates more effectively than quantitative
easing has, potentially making further Fed action redundant.
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All things considered, we think that the FOMC will opt
for a modest extension of its quantitative easing program,
initiating what some have called QE III. As we discussed
earlier this week, we
don’t think that the Fed will lower the interest rate it pays on
excess reserves (IOER).
Here are the key factors we think will carry the day.
- The Fed's dual mandate calls for them to work towards
maximum sustainable employment. We seem to be moving in the
opposite direction of that aim. Inflation seems to be
well-contained, allowing room to address the jobless issue.
- The paralysis in Congress, likely to last for the balance of
this election year, does place additional pressure on the Fed to
be accommodative. It might be tempting for the FOMC to throw up
its collective hands in frustration, but quantitative easing has
proceeded for three years now in the face of fiscal gridlock.
- Even if recent statements from Europe are followed by real
action, it will take some time for European economies and banks
to recover from what they have been through. The global picture
will therefore remain a headwind for U.S. growth.
There will no doubt be dissent on this decision from some corners
of the table. But there should be a core of support that can
carry the day.
This will be a close call, so the risk of being incorrect is
certainly high. I’m therefore tempted to research this even
more deeply, but my family has their faces pressed angrily against
the library window. Time to shut down and enjoy the scenery.
The opinions expressed herein are those of
the author and do not necessarily represent the views of The
Northern Trust Company. The Northern Trust Company does not warrant
the accuracy or completeness of information contained herein, such
information is subject to change and is not intended to influence
your investment decisions.
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