JP Morgan On QE 3: "No Way, Jose"
Just out from the only economist at JP Morgan who is even remotely credible, Michael Ferolli.
Our answer is: no. We think it is very, very unlikely. In a nutshell, we don't think the inflation or inflation expectations data are near the point where the Fed would consider further large-scale asset purchases, and even if the inflation data were to start to move in that direction the potential political fall-out is so great that the Fed would be extremely reluctant to purchase more assets.
The recent economic activity data has been decidedly disappointing. By some broad measures such as GDP, it could well be the case that the first half of this year will look even worse than the second and third quarters of last year -- the quarters leading up to the FOMC's decision to purchases another $600 billion of assets. While the growth data may look similar, a crucial difference thus far has been inflation. Last year, core inflation was decelerating through the middle part of the year. So far this year, core inflation has run below the Fed's target but at least it has shown signs of possibly moving back up toward the target. Just as important, inflation expectations were moving down last year; this year they have held up fairly well. These expectations may have received a boost from QE2, a boost which is about to fade. Indeed, the Fed's own measure of 5yr-5yr forward TIPS breakeven inflation expectations is near the lower end of the range seen since the November QE2 decision. Nonetheless, if we are right that growth will improve in the second half this should give some support to pricing power and to inflation expectations.
Even if we are wrong on a second half rebound, we still believe the political hurdle for further asset purchases is tremendously high. The backlash from Capitol Hill after last Fall's decision probably took the Fed off-guard, and the political impact was not a prominent factor debated in the lead-up to the November decision. Our sense is that this time around it would have to be a major consideration, even if such a sentiment is not expressly conveyed in public communications from Fed officials.
In the absence of further asset purchases, what options are available to the Fed if the current soft patch does not prove to be transitory? In a February speech, Vice Chair Yellen discussed some policy options "if there were an unexpected faltering of the recovery." Two options were mentioned, both relating to communications. First, the Fed could adjust forward guidance to push back expectations of the timing of the first hike, and second, they could shift back expectations regarding the timing of when the Fed contracts its balance sheet. Given that it appears the market is currently pricing in very little Fed tightening, either traditionally or through balance sheet renormalization, the marginal impact of either of these steps for easing financial conditions is likely quite limited. As such, it appears that without taking significant political risks there is little the Fed is able to do to support the recovery if growth fails to rebound as anticipated next quarter.
So... anyone feel convinced?
In other words, we just need two more QE 3 denials, before the cock crows, for it to be officially confirmed.
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