We all know that things are bad and getting worse. Goldman's Jan Hatzius take this opportunity to summarize all the various ways in which the global economy is floundering and once again floats the Goldman solution to everything: More QE, this time with a Bill Gross twist, pun and all, where the Fed again pulls a 2009 and goes for MBS: "Our confidence that the FOMC will ease policy once more at the June 19-20 meeting has also grown... Our baseline remains that Fed officials will purchase a mixture of mortgages and long-term Treasuries, financed via balance sheet expansion and possibly coupled with an extension of the forward guidance into 2015. This would be considerably more powerful than an extension of Operation Twist or other ways of changing the composition of the balance sheet, which are possible alternatives but are limited by the relatively modest amount ($200bn) of short-term paper that is still available for sale on the Fed's balance sheet." Well, if anything, global or Fed-based easing will most likely not come before the Greek June 17 elections - after all Greek confidence has to be crushed heading into the Euro referendum, and the only way to do this is by facilitating collapsing markets. So those hoping for a groundbreaking ECB announcement on June 6 will be disappointed. But June 20? That is fair game. We look forward to seeing PIMCO MBS holdings rise to a new all time high when the monthly TRF update is posted in a few days. Also look for something like this in the EURUSD if and when Bernanke "surprises" few at 2:15 pm on June 20.
From Goldman Sachs: Crunch Time
1. Friday’s jobs report for May capped three months of disappointing economic data, with a nonfarm payroll gain of just 69,000 and sizable downward revisions to prior months. This takes the 3-month average jobs gain down to 96,000, the weakest since August 2011, from a peak of 252,000 in February. The household survey showed a decent rebound in May, but on a 3-month average basis—probably a better measure given the noise in this series—employment has grown just 74,000 per month. More broadly, our CAI—a statistical summary of the underlying trend in the 25 most important US weekly and monthly activity indicators—has slowed to 1.7% in the last two months from 3% in early 2012.
2. What lies behind the slowdown? Part of it is clearly due to the reversal of temporary positives, as we had argued back in March. The unusually warm winter boosted the level of seasonally adjusted payrolls by perhaps 100,000 through February, and that boost has gradually reversed since then. There is also some possibility of residual seasonal adjustment distortions from the speed of the late 2008/early 2009 downturn. But temporary factors are not sufficient to explain all of the weakness. The broader point is that final domestic sales growth remains too sluggish, at just 1.5% (annualized) over the past two quarters, to support a healthy recovery.
3. Alongside the slowdown in the real economy, financial conditions have tightened. Our revamped GSFCI has climbed by nearly 50bp since March, as credit spreads have widened, equity prices have fallen, and the US dollar has appreciated. Some of this tightening is clearly a reflection of the weaker US economic numbers, so we should not “double-count” it as a negative impulse to growth. And some has been offset by the accompanying fall in oil prices, which has kept the “oil-adjusted” GSFCI from tightening nearly as much. But there is also a more exogenous factor, namely the intensification of the European crisis as concern about the Greek election and the Spanish banking system has risen. By our estimates, Europe accounts for up to half of the tightening in the GSFCI since April. We estimate that this could shave an additional 0.2-0.4 percentage points from US GDP growth over the next year. This is the main reason why we have pared our GDP estimates slightly and now expect growth to average slightly below 2% over the next year, with Q1 2013 the weakest quarter at just 1.5% due to the likely fiscal tightening then.
4. The hit from Europe could shrink or grow, but the risks are skewed to a worse outcome than our current baseline. Related to this, Huw Pill and team have sketched out three potential scenarios for the Greek exit discussion—(1) more of the same, (2) a proactive Greek exit, and (3) a decision by the ECB to squeeze Greece out gradually. Scenario (1) corresponds roughly to our baseline forecast, which our European team revised to a slightly bigger sequential contraction in the remainder of 2012 and a more shallow recovery in 2013 last Friday. Scenarios (2) and (3) would imply bigger declines in euro area GDP, and probably further tightening in US financial conditions.
5. Our conviction that the stickier inflation period of the past 1½ years is coming to an end has grown. This is not just because of the drop in commodity prices—including the $25/barrel plunge in crude oil prices—and the appreciation of the US dollar but also because labor cost pressures remain absent. Average hourly earnings are still decelerating, and a sharp downward revision to Q4 wage and salary income in last Thursday’s GDP report implies that unit labor costs will be revised down substantially. We expect inflation to be back below the Fed’s target by 2013.
6. Our confidence that the FOMC will ease policy once more at the June 19-20 meeting has also grown. At a time when Fed officials are far short of their dual mandate of maximum employment and 2% inflation, financial conditions should be accommodative and GDP growth should be well above trend in order to re-employ displaced workers and avoid a gradual transformation of cyclical into structural unemployment. Instead, financial conditions are only roughly at average levels according to our GSFCI, and GDP growth is below its long-term trend. Moreover, both financial conditions and growth have been moving in the wrong direction, to a degree that we think warrants action.
7. Assuming they do ease, what are Fed officials likely to do? It is a tricky call because there are many different options on the table. At the most basic level, they could increase the size of their balance sheet, change the composition of their balance sheet, and/or change their forward guidance in a way that pushes rate hike expectations even further into the future. If the easing comes via changes in the size or composition of the balance sheet, they could buy long-term Treasuries, mortgages, or both. If they decide to extend their balance sheet, they could add excess bank reserves or “sterilize” the reserve impact via reverse repos and/or term deposits. They would also need to decide whether to announce a balance sheet extension problem in one go or adopt a meeting-by-meeting strategy. And if they change the guidance, they could simply push out the date for the first rate hike in the statement or make the first hike conditional on an economic criterion such as a nominal GDP target or the Evans proposal (commit not to hike rates until the unemployment rate has fallen, or until inflation has risen, above a specific level).
8. Our baseline remains that Fed officials will purchase a mixture of mortgages and long-term Treasuries, financed via balance sheet expansion and possibly coupled with an extension of the forward guidance into 2015. This would be considerably more powerful than an extension of Operation Twist or other ways of changing the composition of the balance sheet, which are possible alternatives but are limited by the relatively modest amount ($200bn) of short-term paper that is still available for sale on the Fed's balance sheet. We still think that Fed officials might decide to “sterilize” balance sheet expansion via reverse repurchases or term deposits. We may get a better sense on all of these issues from Chairman Bernanke's testimony to the Joint Economic Committee of Congress on Thursday or other Fed speeches this week.
9. What about the objection that rates are already so low that additional asset purchases will either fail to push rates down further or that further rate declines will be ineffective in boosting economic activity? This concern looms a little less large if purchases are focused on the mortgage market, where the zero bound is still further away. It is also important to remember that the low current level of rates incorporates some expectation of further easing, so rates would presumably rise if the Fed decided to do nothing. All that being said, we do have sympathy with the idea that the liquidity trap is moving out the yield curve, and the Fed’s ability to provide support via “conventional unconventional” options—which we define as date-based forward guidance and changes in the size and composition of the balance sheet—is declining. Therefore, the “unconventional unconventional” options— the Evans proposal, a higher inflation target, or a nominal GDP or price level target—deserve another look. Amongst these, we continue to believe that a nominal GDP level target is the most promising. It would provide reassurance that Fed officials will keep monetary policy loose until nominal spending and income have recovered. Once that recovery has occurred, it would provide a natural “exit strategy” from a loose to a tighter monetary policy. However, we do not expect Fed officials to adopt a nominal GDP target or other unconventional unconventional policies anytime soon