As Messers Frank and Paul take on the Bernank this morning, we reflect on the four easing options that the illustrious fed-head laid out in a statement-of-the-obvious that still managed to get the algos ripping. As Goldman notes, his prepared remarks were terse (and lacking in 'easing options' discussion) - cautious on his outlook, concerned at Europe, and fearful of the 'fiscal cliff' - but his response in the Q&A were a little more revealing as he laid out his choices: asset purchases, discount window lending programs, changes in communication about the likely path of rates or the Fed balance sheet, or a cut in the interest rate on excess reserves. We discuss each below but note, just as Goldman believes, that while we think that a modest easing step is a strong possibility at the August or September meeting, we suspect that a large move is more likely to come after the election or in early 2013 (and not before), barring a very rapid further deterioration in the already-cautious near term Fed economic outlook (which we assume implicitly brings the threat of deflation).
Goldman Sachs, US Daily: For Your Consideration, the Next Set of Easing Options
The prepared remarks on monetary policy gave a brief explanation of the intended mode of operation of the "twist" (known in Fed parlance as the maturity extension program or MEP), and recapped the policy stance of the last FOMC statement. Notably, the prepared text did not include any mention of easing options, though some market participants seem to have expected this, judging from recent client conversations and the market reaction immediately following the publication of the testimony. While this omission certainly does not preclude easing at the upcoming meeting, it does suggest that further action is by no means a foregone conclusion at this stage.
As is often the case, the ritualized give-and-take with lawmakers following the prepared remarks was somewhat more revealing. Chairman Bernanke was asked in a few different ways about what would trigger further Fed easing, and what options would be on the table if the Fed chose to do more.
When asked what would trigger more easing, Bernanke said in one response that the Fed wants to see "progress towards more satisfactory labor market conditions" and in another that easing would turn on whether there is "a sustained recovery going on in the labor market or are we stuck in the mud". Of course, he also included comments on the inflation side of the mandate, which were notable for their dovish stance. Bernanke characterized inflation risks as "relatively low now" (though he noted that "not everyone agrees" with this assessment on the FOMC), and even suggested a "modest" risk of a deflationary outcome. Both the ordering of the responses, with the employment side of the mandate always coming first, and the benign view on inflation reinforce our sense that labor market data in general--and the unemployment rate in particular--will be the most important determinant of the timing and extent of further Fed easing.
Pressed to elaborate on what more the FOMC could still do to support the economy, the Chairman described a "logical range" of four monetary easing options: 1) another round of asset purchases focused on Treasuries and/or agency mortgage-backed securities, 2) use of the Fed's discount window for lending purposes, 3) changes in communication regarding the likely path of interest rates or the Fed's balance sheet, 4) a cut in the interest rate on excess reserves (IOER), currently 0.25%. The following table illustrates our estimates of the likely effect of these options, along with some pros and cons of each.
The notable new item on this list is the use of the Fed's discount window. (An IOER cut has been discussed on previous occasions and apparently rejected, so its appearance here is not new but does suggest a re-evaluation of the cost/benefit tradeoff associated with this tool. One reason for its return may be the recent "demonstration effect" of the cut in the European Central Bank's deposit rate, which does not appear to have caused significant market disruption.) At the June press conference, the Chairman responded with enthusiasm when asked about the Bank of England's "funding for lending" program, and it appears that he has something along these lines in mind -- a program of "credit easing" aimed at areas of the economy where credit availability is still constrained, residential mortgage lending being the most obvious example.
How might this work and would it be effective? The Bank of England's program creates a facility whereby banks can exchange government securities for mortgage loans, and then use those government securities to obtain cheaper funding via the repo market. The amount and cost of funding available for each bank will depend on its rate of loan growth, with funding available for a portion of the existing loan book plus all incremental lending, and costs designed to ensure that the marginal incentive for new lending is high. (For more details see Kevin Daly, "BoE/Treasury announce details of the "Funding for Lending Scheme", European Views (UK), July 13, 2012.)
Relative to the situation in the United Kingdom, it is less clear that an analogous Fed program would be effective. US housing activity is clearly improving already. Also, according to a rough estimate from our banking analysts, US banks' funding costs are about 100bp lower than UK banks on average, with a ca. 65bp all-in weighted cost of funding. So the potential drop in US bank borrowing costs from a BoE-like scheme appears more limited. This raises the question of how much additional lending to end users would be incentivized, even leaving aside the possible reluctance of banks to participate in such a program. Of course, Fed officials' ability to provide incentives is also limited by their inability to take private-sector credit risks. Thus, at this early stage, we see any such program as likely to have a fairly modest impact.
What then should we expect from the FOMC at its upcoming meeting on August 1? As previously noted, the lack of inclusion of easing options in the prepared testimony suggests a lower probability of a "big" easing step, at least on the margin. Furthermore, Bernanke has defended the recent extension of the twist as a "substantive" easing; this is one reason why we have been doubtful that another asset purchase program would follow it quickly (see Jan Hatzius, "Bernanke Preview", US Daily, July 16, 2012). The seemingly biggest easing option on the table, asset purchases, is the most controversial, and any "funding for lending scheme" probably will require somewhat more preparation and planning. This leaves a cut in IOER, which would seem very small by itself, or an extension in the rate guidance. To us, extending the current guidance that rates will remain "exceptionally low….at least through late 2014" seems the path of least resistance should the Fed choose to ease in August or September. Moving the guidance out to mid-2015 would simply maintain the nearly three-year freeze implied by the current guidance when it was originally rolled out in January.
The bottom line: our base-case expectation is for an extension of the rate guidance by September, with a larger easing action (asset purchases or a "credit easing" program) in December or early 2013.