We highlighted the following report from St. Louis Fed's Daniel Thornton in today's Frontrunning, but it may bear repeating as it is the first written salvo in the internal Fed trench warfare over QE2. The report is no surprise: as St Louis is the bastion of Daniel Bullard, one of the biggest non-voting hawks at the Fed, a group which is increasingly getting more vocal with such others as Philly's Plosser and Dallas' Fisher, not to mention Atlanta's Hoenig, the paper titled "Would QE2 Have a Significant Effect on Economic Growth, Employment, or Inflation?" is merely an attempt by the sensible undercurrent at the Fed to distance itself from the policies enacted by the supreme madman in charge of it all. While the report says nothing notably new, it does repeat what all QE2 skeptics know all too well: "It is possible – perhaps even likely – that almost all of any increase in
the supply of credit associated with QE2 simply would be held by banks
as excess reserves. If so, the effect of QE2 on
interest rates could be small and limited to an announcement effect –
the effect associated with the FOMC’s announcement – independent of the
effect of the FOMC’s actions on the credit supply." Which begs the question - why is this report coming out now? Is this the red herring to the lack of a QE2 announcement on November 3? With everyone certain monetization is imminent and inevitable, is everyone about to end up on the wrong side of the trade? And if so, just how far will the market crash, now that at least 150 S&P points worth of QE2 are priced in...
Some other logical concerns by Thornton, focusing on output and unemployment:
Even if QE2 did affect interest rates, many believe that the effect on output or employment would be small. For example, Charles Plosser, president of the Philadelphia Fed and a nonvoting member of the FOMC, recently suggested that “[I]t is difficult…to see how additional asset purchases by the Fed, even if they move interest rates on long-term bonds down by 10 or 20 basis points, will have much impact on the near-term outlook for employment.” One reason is that even in normal times, investment spending is not particularly responsive to changes in interest rates: Investment spending depends more on the economic outlook. Consequently, some analysts believe that reducing interest rates modestly from their already historically low levels is unlikely to stimulate aggregate demand: Little effect on aggregate demand implies a corresponding small effect on output and, hence, employment.
On QE2 and inflation expectations:
The effect of QE2 on inflation or inflation expectations is also uncertain. According to modern macroeconomic theory, inflation is determined by (i) economic agents’ inflation expectations and (ii) the gap between actual and potential output. Currently, the estimated gap between actual and potential output is negative and large. Consequently, in order to affect inflation by the gap mechanism, QE2 would have to significantly increase output relative to potential, but (as noted above) the effect on output is questionable.
On QE2 and hyperinflation expectations:
Some analysts and market participants believe inflation is the consequence of excessive money growth. That is, excessive money growth increases inflation independent of the size of the output gap or inflation expectations. Growth of the M1 and M2 monetary aggregates accelerated sharply after the Fed began QE in September 2008, but then declined as banks increased their holdings of excess reserves. If banks decide to hold most or all of QE2 as excess reserves, there would be no corresponding increase in the money supply and, consequently, no increase in inflation. Some analysts are already concerned about the potential inflation consequences of the Fed’s previous QE measures. To the extent that QE2 would exacerbate those concerns, it could raise inflation expectations. However, it is questionable whether inflation expectations would rise appreciably without either a corresponding increase in actual inflation or the FOMC signaling a higher inflation objective.
Alas, the FOMC has just signalled a higher inflation objective.
And lastly, QE2 as going straight to the heart of Fed credbility:
Finally, it should be noted that QE2 could have adverse effects. For example, Plosser has expressed concern that if the FOMC undertakes QE2 and the actions are ineffective, it could damage the “Fed’s credibility and possibly erode the effectiveness of our future actions to ensure price stability.” He suggests that QE2 might also raise concerns that “the Fed is seeking to monetize the deficit [which] might make it more difficult to return to normal policy” in the future.
Bottom line: buy lots of still cheap puts ahead of November 2. Something strange is going on here.