Goldman On The Fed: Perception Over Substance

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Perhaps never a more truthful 'lifting-the-veil' paragraph has been written by the squid as the following discussion of just what NEW QE will consist of and what it will achieve; sad that our economy market has come to this.

"The form of any return to QE is less clear. The issue is not so much whether the Fed buys Treasuries or agency mortgage-backed securities; we are pretty sure that any new program would be primarily focused on agency MBS purchases. These should have a somewhat bigger per-dollar effect on private-sector demand and are probably less controversial with the public than Treasury purchases. They can be framed as help for homebuyers to achieve the American Dream, which sounds better than help for the government to run large budget deficits."

Contrasting with the consensus view that we must eat cake QE3, Goldman tends to agree with Michael Woodford's recent J-Hole note that "large-scale asset purchases are neither necessary nor effective in easing financial conditions, at least not beyond the signal they convey about future short-term interest rates" and as we explained on Friday (Scary Math Of QE), the Fed is limited by Treasury market size in its monetization efforts there, and by the scarcity of MBS new issuance and availability in the MBS market. However, paradoxically, they still expect an open-ended QE2-plus size new LSAP and forward rate guidance moves - since that is what the market demands (and they believe QE still has some 'juice' and that Fed officials also believe this).

 

Goldman Sachs: Belt and Suspenders

1. The modest improvement in the US growth pace seen earlier in the third quarter has stalled in recent weeks. Our Q3 GDP tracking estimate has come down a touch to 2.3%, and our Current Activity Indicator (CAI) stands at just 1.1% for August with the data in hand so far, down from 1.4% in July. In terms of our own views on the economy, we’re not sure how much of a signal to take away from this slight deterioration, as it could just represent noise in the data. Our best guess is still that growth in the second half of 2012 will be a little better than in the first half. One important reason is that consumer spending has gotten off to a very good start in the third quarter, judging from July personal consumption and August retail and auto sales. But the slowdown in real income growth that is implied by the weakness in payrolls, hours, and wages in August, as well as the ongoing backup in seasonally adjusted gasoline prices, have lowered our confidence in that forecast.

 

2. Fed officials are virtually certain to ease monetary policy at the September 12-3 FOMC meeting. The minutes of the July 31-August 1 FOMC and Chairman Bernanke’s Jackson Hole speech were loud and clear. If the chairman harbors a “grave concern” about the labor market, presumably he intends to do something meaningful about it. The employment and ISM numbers have removed the remaining doubts, and everything now points to a substantial easing step.

 

3. Must this step involve QE? In theory, not necessarily. In a much-discussed study presented at Jackson Hole, Michael Woodford of Columbia University argues that the Fed could (and should) just focus on strengthening its forward guidance for the funds rate, preferably via a nominal GDP level target or alternatively via the 7/3 rule proposed by Chicago Fed President Evans (no hikes until the unemployment rate is below 7%, unless underlying inflation rises above 3%). In contrast, Woodford believes that large-scale asset purchases are neither necessary nor effective in easing financial conditions, at least not beyond the signal they convey about future short-term interest rates.

 

4. In principle, we agree with Woodford that a nominal GDP level target could be powerful, and it might even be sufficient on its own for the Fed to reach its dual mandate in a reasonable time frame. However, Fed officials do not seem close to such an aggressive move. Apart from the difficulty of communicating to the public how a nominal GDP target relates to their dual mandate, their biggest worry is that the roughly 10% gap between actual nominal GDP and the pre-crisis trend might be closed primarily via a period of temporarily higher inflation, and that this might destabilize longer-term inflation expectations. (We agree that this is a risk, although our model simulations suggest that most of the make-up nominal growth would probably occur via make-up real growth rather than above-target inflation.)

 

5. In Woodford’s model, a central bank essentially loses its ability to pull the economy out of a liquidity trap if it refuses to provide aggressive, state-dependent forward guidance. However, we believe Woodford is a little too pessimistic about the ability of large-scale asset purchases/QE to ease financial conditions directly (that is, beyond the signaling effect for future short-term rates). Our own work suggests that QE has a meaningful effect on bond yields in its own right, and that the interaction between QE and forward guidance makes the QE effect even more powerful. Of course, it is entirely plausible that these effects are now smaller than they were at the start of the period of near-zero short rates in 2009 and 2010. But our best guess is that there is still some “juice” in further QE, and it is clear that Fed officials agree. We therefore believe that the Fed will employ a belt-and-suspenders approach and start another QE program alongside an extension of the forward guidance to mid-2015 or beyond.

 

6. The form of any return to QE is less clear. The issue is not so much whether the Fed buys Treasuries or agency mortgage-backed securities; we are pretty sure that any new program would be primarily focused on agency MBS purchases. These should have a somewhat bigger per-dollar effect on private-sector demand and are probably less controversial with the public than Treasury purchases. They can be framed as help for homebuyers to achieve the American Dream, which sounds better than help for the government to run large budget deficits.

 

7. Will a new program be specified as a fixed up-front amount or in more open-ended terms? We are leaning toward an open-ended program because it is both more flexible and more in line with the insight underlying the Woodford study that the policy should be conditional on the state of the economy, not the calendar. If we are right and Fed officials do adopt an open-ended program, the key question is how they will specify the criteria for how long it will last. At one extreme, they could simply say that the program will stop when the committee is more satisfied with the progress of the recovery. At the other extreme, they could write down hard numbers for the unemployment rate and inflation. In practice, we expect a middle ground approach, perhaps via a high-level description in the FOMC statement followed by some more concrete examples in Chairman Bernanke’s ensuing press conference.

 

8. There is a related question around the formulation of the forward funds rate guidance. We agree with Woodford’s criticism of the current formulation, which essentially says that “we expect the economy to remain weak enough to keep the funds rate low.” A better message would be that “we intend to keep the funds rate low in order to generate a stronger economic recovery.” There is a good chance that that the committee will move in this direction, in addition to lengthening the guidance to at least mid-2015.

 

9. How much should we expect from a new round of easing? Our estimates suggest that a program equivalent to QE2 plus an extension of the forward guidance to mid-2015 might boost GDP growth by ¼-½ point over the next year. We would expect an impact toward the top end of the range if the QE program is more open-ended and/or the forward funds rate guidance moves in the direction of a Woodford-style state dependent formulation. But even if the FOMC errs on the side of a more aggressive move, we expect GDP to grow little more than 2% next year, similar to this year’s pace.

 

10. One key reason for this cautious view is that we have become more worried about fiscal policy over the past few months. Even our baseline expectation—an agreement during the lame-duck session to avert most of the income tax increases and automatic spending cuts—implies a hit of 1.2% of GDP in 2013. By far the largest component of this drag is the likely end to the payroll tax cut, which implies an increase in taxes primarily on middle-income earners of $120 billion. And we are far from certain that a compromise will be found in time, as another game of brinksmanship looks all too possible. If this results in the 3.5%-4% of GDP fiscal tightening implied by current legislation—not our forecast but nonetheless a significant risk—even a decisive move to renewed monetary easing would probably not be enough to prevent another recession.

 

Source: Goldman Sachs