After 3 months ago everyone was convinced there was no QE3 imminent ever, all it took for the lemming majority to scramble to the other side of the boat was a 20% drop in stocks. Since then, following a brief stabiliziation in stocks, based precisely on beliefs that Bernanke would once again pull something from this bag of goodies, the lemmingrati once again shifted back, and the majority now pretends it does not expect anything out of Jackson Hole tomorrow, even though it obviously does, as otherwise the market would resume its plunge. UBS earlier conducted a survey among money managers, finding that 50% of the 82 respondents expect Bernanke to limit Jackson Hole remarks only to reviewing the rationale for the Fed to pledge ZIRP until mid 2013. Then there are those who actually told the truth, such as Goldman which, in a note yesterday, says that $1 trillion in QE3 is an absolute minimum if the Fed wants to get GDP higher by at least 0.5%. To wit: "Taken together, our analysis suggests that QE3 is unlikely to be a panacea for growth. Nonetheless, our estimates suggests that $1trn of asset purchases–or an equivalent increase in the duration of the Fed's balance sheet–might increase GDP growth by up to 0.5 percentage point in the first year after any announcement of QE3." And since we are talking the truth here, why not stop pretending you care about GDP - just think of the marginal impact on Wall Street bonuses...
First, the UBS responses:
- 18% expect Fed will extend average maturity of Treasury holdings, similar to “Operation Twist”
- 3% expect either “QE3 Max” (purchases include risky assets or a 10-yr yeld target) or a QE3 along the lines of QE2
- “We suspect that a reasonable chunk of the nearly 4% gain in the S&P 500 this week is built on the hope that the speech is friendly to risk assets. Hence they could suffer at least a bit if the Chairman does not pave the way for QE3”
One firm that is not shy about its "QE3 or bust" policy, er, recommendation is Goldman. Here is the firm's Sven Jari Stehn defending the firm's outlook why a $1 trillion boost in LSAP (or duration equivalent extension, because see, LSAP is the same as Operation Twist from a risk preference shift perspective, but unfortunately twitter-poll responding FX traders are unable to grasp this...). As a reminder, it was Goldman who was calling for $2 trillion in QE2 only to get $900 billion. Compromise? And does this mean that Bernanke will merely implement $500 billion in Operation Twist 2 then? We shall find out tomorrow.
That said, if the Chairman disappoints, the market will not be happy.
From Goldman Sachs:
Following the sharp deterioration in the economic outlook, we now see a greater-than-even chance that the Federal Open Market Committee (FOMC) will resume quantitative easing later this year or in early 2012. We recently discussed that such a step might involve either another expansion of the balance sheet or an increase in the duration of the Fed's balance sheet without expanding it (see "For More Easing, Will Fed Go Big or Go Long?" US Daily, August 15, 2011.) But given the disappointing growth performance since the adoption of the second round of asset purchases ("QE2") late last year, many commentators question how effective QE3 would be in boosting the sluggish recovery. In today's comment we attempt to shed some light on this question in two steps.
First, we reexamine the link between quantitative easing and financial conditions. As discussed on many occasions in the past, we think that the Fed's unconventional policies work primarily through easing financial conditions via lower interest rates, higher equity prices and a weaker dollar. Specifically, we estimated in the run-up to QE2 last summer that $1trn of asset purchases would boost our financial conditions index (GSFCI) by around 80 bps. (This estimate was derived as the average effect from three models that ranged from 25-115bp. For details see Sven Jari Stehn, " Unconventional Fed Policies and Financial Conditions: How Tight a Link?" US Daily, August 17, 2010.)
Using our previous methodology, we update these estimates to include QE2. Specifically, we explain the level of the GSFCI with three components. First, we include the announced stock of the Fed's asset purchases (that is the announcements in November 2008, March 2009 and November 2011 to purchase $600bn, $1.15trn and $600bn of securities, respectively). Second, we include the target fed funds rate (as a measure of the current stance of conventional monetary policy) and the slope of the Eurodollar curve (to capture expectations for future monetary policy). Finally, we include a number of economic variables that capture other economic influences, including Reuters/University of Michigan long-term inflation expectations and initial jobless claims. We estimate this model using weekly data between January 2000 and August 2011. We find that the first two rounds of asset purchases, on average, eased financial conditions by 101bp per $1trn (see column 1 in the table below). This estimate is consistent with our previous range of estimates, but a bit higher than their average.
The Estimated Effect of Fed Asset Purchases
There is, however, reason to believe that QE3 might be less effective in easing financial conditions than the first two rounds of purchases. This is because Fed asset purchases are likely to have larger effects during times of extreme market stress, and particularly when they are targeted at a specific market dislocation, like the mortgage-related purchases during QE1. As a result, one would expect that QE1 had a more significant effect on financial conditions than the subsequent program. Unfortunately, it is difficult to test for this empirically as we only have two experiences to go by. That said, we find some tentative evidence that the effect of QE1 on financial conditions was larger than during QE2: the effect rises to 120bp per $1trn when we estimate the model only through the end of QE1 in March 2010 (see column 2 above). To the extent that this finding points to diminishing returns to quantitative easing, we might expect additional purchases to ease financial conditions by less than 100bp per $1trn of purchases (or an equivalent extension of the average duration of the balance sheet).
Moreover, the effects of further quantitative easing on financial conditions might well be dampened by the Treasury's debt management policies. This is because in an environment where the federal funds rate is near zero, asset purchases–whether financed by the creation of bank reserves or by selling short-maturity holdings–are essentially equivalent to a shortening of the average maturity of the government debt. (For details of this argument see Jan Hatzius, "QE2 as a Shortening of Treasury Debt Maturities," US Daily, October 26 2010.) The average maturity of the privately held Treasury debt, however, has recently been increasing despite QE2–up from 57 months in October 2010 to 58 months in March 2011 (the latest available figure). If this trend continues, the effects of QE3 on financial conditions may be at least partially offset by the Treasury’s debt management policies.
Having discussed the effect of quantitative easing on financial conditions, we turn to the link between financial conditions and growth. Our estimates–summarized in the chart below–suggest that a 100bp easing in financial conditions would boost growth by 0.8 percentage point in the first year and another 0.2 percentage point in the second–i.e., raise the level of real GDP by 1% after two years. (For details see Sven Jari Stehn, "Another Look at the Link Between Financial Conditions and Growth," US Daily, October 26, 2010.) The chart below furthermore breaks down the total effect into its components, suggesting that about half of the total effect of the easing in financial conditions on GDP can be explained by an increase in consumer spending. The response of fixed investment, housing and net exports to easier financial conditions also contributes significantly to GDP growth.
The Effect of Easier Financial Conditions on GDP
Again, we see a couple of reasons why this link might be weaker in the current context. First, the disappointing growth performance in 2011H1 suggests that the effect of the easing in financial conditions in 2010H2 might have been smaller than the above estimates imply. A possible explanation is that some of the normal transmission channels seen in the chart above might be "clogged" in the current environment. In particular, a significantly positive effect on housing construction seems unlikely given the large amount of unoccupied inventory that currently hangs over that market. Moreover, the response of consumption might well be more muted in light of households' inability to extract equity from homes through refinancing due to widespread negative equity. In a simple attempt to capture these effects, we fully exclude the contribution of residential investment to GDP growth implied from the chart. (An alternative approach would have been to exclude parts of both the housing and consumption response.) Doing so suggests that a 100bp easing in financial conditions might boost growth by only 0.5 percentage point in the first year (see dashed line). Second, it is possible that rising energy prices might offset some of the growth effects of any QE3-induced easing in financial conditions. Although we agree with the view expressed by Fed Vice Chair Janet Yellen–that commodity prices are best explained by the fundamentals of global supply and demand rather than by the stance of US monetary policy–the significant increase in crude oil prices before and after the QE2 announcement raises the question whether there might have been at least some offset to the easing in financial conditions. In support of this view, our "oil-adjusted" financial conditions index–which takes into account the price of crude oil–shows less easing in response to the Fed's purchase programs than the GSFCI.
Taken together, our analysis suggests that QE3 is unlikely to be a panacea for growth. Nonetheless, our estimates suggests that $1trn of asset purchases–or an equivalent increase in the duration of the Fed's balance sheet–might increase GDP growth by up to 0.5 percentage point in the first year after any announcement of QE3.