The odds of Fed easing at the September FOMC meeting seem close to 50-50 (with both sides vehemently talking their books - Fed officials and equity managers alike). Recent data has been a bit better: payrolls, claims, retail sales, and industrial production. As UBS' Drew Matus notes, other factors that will play a role include the ISM report, claims reports, and 'fiscal cliff'-related events. However, the primary determinant will be the upcoming August payroll report. The chart below ignores these other factors and offers up the odds of further easing in September based on the base case that Bernanke’s primary concern is the state of the US labor market. July’s 8.3% unemployment rate and payroll gain of 163k put current odds of further easing at 45%.
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We look for Chairman Bernanke’s August 31st speech kicking off the Jackson Hole Conference to explain what mechanisms the Fed would use to ease further but avoid promising that further easing will be forthcoming. We believe that additional easing is conditional primarily on the behaviour of the labor market. Prior to the FOMC’s decision on September 13th, there will be an additional payroll report and two additional initial claims releases.
Alternatively, the absence of a detailed discussion on easing options may signal the Fed is more likely to wait until after the US election, resetting market expectations to the December 12th FOMC meeting.
We expect Chairman Bernanke to lay out a path of additional easing that would follow the Bank of England’s (BOE) “Funding for Lending” scheme to address the transmission mechanism of monetary policy rather than simply provide additional liquidity to market participants. We believe this experiment by the BOE will provide the inspiration for a Fed program through which banks would be rewarded (vis-à-vis the Discount Window) for meeting targets related to their behaviour: increasing bank lending, accommodating distressed mortgage refinancing or writing down principal for outstanding loans.
Although we would not necessarily expect a new program to provide much of a boost to the US economy, it would show that the Fed is willing to do more non-traditional activity and is willing to boost the size of its balance sheet to improve US economic outcomes. It would likely prove an appealing experiment for Chairman Bernanke and would have several advantages relative to another round of quantitative easing (QE).
- First, it would not increase concerns around the proper functioning of either the US Treasury or mortgage-backed securities markets. This would be a significant advantage should the US hit the fiscal cliff, with the resulting sharp decline in Treasury debt issuance.
- Secondly, the program would not immediately increase the size of the Fed’s balance sheet and would also likely not be as large as a QE program, limiting the impact on the currency.
- Thirdly, the program would be more efficient as any subsidy would be directly tied to an improvement in lending/loan forbearance; in contrast, earlier QE arguably has boosted excess reserves more than lending.
- Additionally, it is important to note that nothing would preclude further QE at a later date.