Goldman's FOMC Script/Playbook
With 20 minutes to go, we thought it timely to see the script (perhaps) for the frivolity to come. It seems like the fate of the known world is predicated on the words of a bearded academic this afternoon and whether you believe he must or must not LSAP us to Dow 20,000 (and Gold $2,000) in the next few weeks - even as the economy and jobs tail-spin - there are many questions, which Goldman provides a platform for understanding, that remain unanswered (and more than likely will remain vague even after he has finished his statement). Their expectations are for a return to QE and an extension of rate guidance into mid-2015 (and everyone gets a pony) but no cut in IOER.
Via Goldman Sachs
Q: What is your baseline expectation for the outcome of the FOMC meeting?
A: An easing of monetary policy is very likely. Moreover, we expect a substantial step, given the extensive discussion of easing in both the minutes and Chairman Bernanke's speech at Jackson Hole, as well as the somewhat weaker-than-expected data released since then. We see two main scenarios for delivering such a substantial step:
- A combination of large-scale asset purchases (QE) with a lengthening of the forward guidance for the funds rate from late 2014 to at least mid-2015. This is our baseline expectation. It is in line with the policy options discussed in Chairman Bernanke's Jackson Hole speech, as well as the minutes of the July 31-August 1 meeting. Both of these gave a prominent role not just to forward guidance but also to QE (the chairman's speech mentioned it first). Moreover, it is at this point widely expected in the financial markets, which somewhat raises the cost of not delivering it.
- A more substantial enhancement of the forward guidance, perhaps to the point of adopting the 7/3 rule—no hikes until the unemployment rate has fallen below 7% unless inflation rises above 3%—proposed by Chicago Fed President Evans. But this is less likely, in our view. The FOMC probably feels that if it failed to deliver on expectations of renewed QE—which are of course largely based on its own communications—it would need to make up for this by not just lengthening but also substantially revamping the guidance. However, we suspect that the committee is not yet ready for an Evans-style 7/3 rule.
Q: Isn't it surprising that there has been such a strong push in the direction of additional easing, given the slightly greater stability in the economic data, the improved situation in Europe, the easing in financial conditions, and the impending presidential election?
A: Yes, it has been a bit surprising. One possible explanation is that the committee has shifted to greater concern about the fiscal policy outlook and the possibility of substantial drag from this source in early 2013. Another possibility is that it has simply taken the committee some time to react to the deterioration in the data and outlook that took place during the spring and early summer. In an institution as large as the Federal Reserve System, forging consensus around a shift in the policy can be a time-consuming process. This was less true under Chairman Greenspan than under Chairman Bernanke, who has tried to make the decision-making process more democratic, and it was also less true during the financial crisis when the Fed leadership was more willing to charge ahead to head off imminent economic and financial threats. But in an environment such as 2012--—a crisis situation but one in which the economy once again has disappointed the Fed's hopes for a substantial growth pickup—the lag has been a bit longer.
Q: Assuming a return to QE, what form will the program take?
A: We expect an unsterilized, open-ended program that is specified as a flow rate of purchases. We believe an open-ended program is attractive to many FOMC members. Those who want to provide a lot more support to the economy like the fact that an open-ended program has a "whatever it takes" aspect to it and is more clearly focused on generating an economic recovery; indeed, Presidents Evans, Rosengren, and Williams are on record as supporting open-ended QE. But at the same time, those who worry about committing to excessive stimulus may also be willing to go along with this, at least as long as the program is characterized as one that could be discontinued relatively easily if the outlook shifts. St. Louis Fed President Bullard may be in this latter camp. That said, the leadership has not yet shown its hand on this issue, so it remains uncertain which option the committee will choose.
If the FOMC does adopt an open-ended program, one key question is how the conditions for ending it will be specified. At one extreme, they could simply say that the program will end when they feel they are closer to reaching their mandate. At the other extreme, they could specify hard-and-fast criteria in the FOMC statement that will automatically end the program. In practice, we would expect them to steer a middle course, with fairly general phrasing in the statement and some explanation in the chairman's press conference.
In our conversations with investors, some have raised the concern that a shift to a flow rate of purchases may be taken as a signal that the Fed has moved away from the "stock" view of the impact of QE/LSAPs, in which the level of interest rates and financial conditions depends on the level of Fed asset holdings, toward a "flow" view, in which the level of rates depends on the rate of purchases. We do not agree with this. Market participants will form an expectation for how long the purchases will last, depending on the Fed's signals about the conditions that need to be fulfilled for it to end and the market's economic expectations. These expectations will turn the announced flow rate of purchases into an expected stock of securities holdings, which determines the impact on bond yields and asset prices.
Q: How large will the program be? How much will be in mortgage-backed securities vs. Treasuries? And what happens to Operation Twist 2?
A: These questions are all related, so it makes sense to answer them together. We see two basic options:
- A moderately sized program that runs concurrently with the Maturity Extension Program (aka Operation Twist) through the end of the year. This is our baseline expectation. If the committee chooses this option, we would expect them to go for a monthly flow of purchases of around $50bn, allocated mainly to the MBS market. Together with the Twist, this would imply monthly purchases of long-end securities of nearly $100bn over the next few months. At the end of the year, a decision would need to be made whether to maintain significant purchases of longer-term Treasuries via an expansion of the QE program that compensates for the end of Twist.
- A bigger program that replaces Twist. In this case, we would expect the committee to go for purchases of around $75bn per month, and the purchases would probably be more tilted toward Treasuries to compensate for the end of Twist. This would imply a smaller amount of duration removal in the short term. However, if it really is an open-ended program, it would be a commitment to a larger amount of duration removal beyond year-end 2012, and this is why we would be surprised by anything larger than $75bn per month.
Q: How might the guidance be reformulated?
A: We believe there is a widespread sentiment in favor of shifting the guidance more in the direction advocated by Michael Woodford's Jackson Hole study. This would mean shifting from an emphasis on the expectation that economic weakness will hold down rates to an emphasis on the desire to keep rates low in order to promote economic recovery. For example, the statement might say that "the Committee expects to hold the federal funds rate at exceptionally low levels through mid-2015 in order to promote a stronger economic recovery."
A more radical reformulation would be an adoption of the 7/3 rule, or something similar. We doubt that there is agreement on such a relatively aggressive change in the guidance just yet. Many Fed officials are probably still worried about committing to a particular unemployment rate, even with the "safety valve" of a maximum inflation rate. However, we would not entirely rule out such a move, especially if the committee decides against a return to QE at this meeting.
A yet more aggressive move would be a move to a nominal GDP level target. This is highly unlikely at this meeting. However, continued disappointments in the pace of the recovery could shift the debate in this direction in 2013-2014.
Q: Will they cut the interest rate on excess reserves (IOER)?
A: We do not expect an IOER cut at this meeting. The main argument against expecting it is that the committee has repeatedly considered an IOER cut below the current 0.25% and has rejected it every time. The prevailing view has been that while a cut would slightly reduce money market rates and slightly increase the incentive for banks to lower their lending rates and loosen their standards, this relatively small effect is unlikely to compensate for the potential disruptions in the money markets resulting from a rapid shutdown of money market funds that are no longer able to cover their costs. Indeed, the balance of opinion at the last FOMC meeting seems to have been negative: "While a couple of participants favored such a reduction, several others raised concerns about possible adverse effects on money markets." Moreover, Chairman Bernanke did not mention it in his Jackson Hole speech.
That said, we would also not entirely rule out an IOER cut. "A couple" of FOMC meeting participants did favor a cut at the last meeting. Moreover, the minutes noted that "…the ECB's recent cut in its deposit rate to zero provided an opportunity to learn more about the possible consequences for market functioning of such a move." Our reading is that these consequences have been minor, at least in the case of Europe. Finally, it was noteworthy that Atlanta Fed President Lockhart said in a recent interview with the Wall Street Journal that while he was not sure whether additional monetary easing was needed, a package of "two or three" measures would likely be appropriate if easing did occur. We suspect that an IOER cut is the third measure on Lockhart's list, after guidance and QE.
Q: What do you expect to see in the Summary of Economic Projections (SEP)?
A: We expect only a minor downgrade in the economic projections for 2013 and 2014 (see Exhibit 1).
As for 2015, we expect a forecast of a pickup in GDP growth to 3pc or a bit more, stable inflation, and a moderate decline in the unemployment rate to just over 7%. As for the date of the first policy firming, we will likely see participants push back the hikes substantially, as shown in Exhibit 2.
Presumably Chairman Bernanke will move his view from 2014 to 2015, and other officials (especially the Washington-based governors) are likely to follow suit. It is unclear whether the participants who thought back in June that the appropriate timing of policy firming was in 2012—probably Presidents Fisher, Lacker, and Plosser—continue to hold this view. We have assumed that they do.