Confused why every asset class is up again today (yes, even gold), despite the pundit interpretation by the media of the FOMC statement that the Fed has halted more easing? Simple - as we said yesterday, there is $3.6 trillion more in QE coming [23]. But while we are too humble to take credit for moving something as idiotic as the market, the fact that just today, none other than Goldman Sachs' Jan Hatzius came out, roughly at the same time as its call to buy Russell 2000 [24], and said that the Fed would announce THE NEW QETM, as soon as next month, and as late as June. Furthermore, as Goldman has previously explained, sterilization of QE makes absolutely no difference on risk asset behavior, and it is a certainty that the $500-$750 billion in new money (well on its way to fulfilling our expectation of a total $3.6 trillion in more easing to come), in the form of UST and MBS purchases, will blow out all assets across all classes, while impaling the dollar. Which in turn explains all of today's action - dollar down, everything else (including bonds, which Goldman said yesterday [25]to sell which we correctly, at least for now, said was the bottom in rates) up. Finally, as we said, yesterday, "In conclusion we wish to say - thank you Chairman for the firesale in physical precious metals." Because when the market finally understands what is happening, despite all the relentless smoke and mirrors whose only goal is to avoid a surge in crude like a few weeks ago ahead of the presidential election, gold will be far, far higher. Yet for some truly high humor, here is the justification for why the Fed will need to do more QE, even though Goldman itself has been expounding on the improving economy: "The improvement might not last." In other words, unless the "economic improvement" is guaranteed in perpetuity, the Fed will always ease. Thank you central planning - because of you we no longer have to worry about either mean reversion or a business cycle.
Oh, and if someone at the Dallas Fed could be so nice to bring the following statement to the attention of Dick Fisher, we woul dbe very grateful: "Not easing might be equivalent to tightening." Because last we checked Dick was shocked, SHOCKED, that the market is addicted to QE...
As for Goldman, if one ignores all of the below, the only thing to remember is that Goldman is now selling stocks to, and buying bonds from the muppets.
From Goldman Sachs
Q: What is your current forecast for Fed policy?
A: It has definitely become a closer call, but we still expect another asset purchase program that involves purchases of both mortgage-backed securities and Treasuries. This would expand the Fed's balance sheet, but its impact on the monetary base would likely be "sterilized." We expect this program to be announced in the second quarter, either at the April 24-25 FOMC meeting or the June 19-20 meeting. The argument for April is that this would leave more time before the end of the long-term bond purchases under Operation Twist (more formally known as the Maturity Extension Program), and would thereby reduce the risk of market disruptions as uncertainty about the Fed's role in the market rose. The argument for June is that this would allow Fed officials a bit more time to assess the state of the economy. After June, we believe the hurdle for more action rises, not so much because of the impending presidential election but more because a decision to wait until after the end of Operation Twist would signal greater comfort on the Fed's part with denying the economy additional stimulus.
Q: The economic indicators are improving, financial conditions remain accommodative, and inflation is at or above the Fed's target. So why should they ease further?
A: We see three reasons why additional Fed easing may well be warranted despite the improving data:
1. The improvement might not last.
As we discussed yesterday, the job market numbers and broad indicators of economic activity such as our Current Activity Indicator (CAI) have shown a significant upturn recently (see Andrew Tilton, "Conflicting Signals on US Growth," US Daily, March 13, 2012). However, with real GDP growth tracking just 2% in the first quarter and signs that at least some of the recent strength is probably due to the unusual warm weather and perhaps some seasonal adjustment distortions, question marks still surround the true pace of activity growth. In addition, there are still several actual or potential "headwinds" for growth, including a reduced boost from inventory accumulation, the recent increase in oil and gasoline prices, continued risks from the crisis in Europe, and the specter of fiscal retrenchment after the presidential election.
2. Even if the improvement does last, faster growth would be desirable to push down the unemployment rate more quickly.
Fed officials believe that the level of economic activity and employment is still far below potential. This means a large number of individuals are involuntarily unemployed, which not only causes hardship in the near term but may also translate into higher structural unemployment in the long term (see for example Sven Jari Stehn, "Can Additional Stimulus Prevent Labor Market 'Hysteresis'?" US Daily, September 15, 2011.) This creates an incentive to find policies that speed up the return to full employment.
3. Not easing might be equivalent to tightening.
At a minimum, the bond market currently discounts some probability of QE3. This has kept financial conditions easier than they otherwise would have been, which has presumably supported economic activity. A decision not to ratify expectations of QE3 could therefore result in a tightening of financial conditions.
Beyond this, there is also a possibility that financial conditions have been kept easier via the "flow" of long-term Treasury purchases under Operation Twist. In general, we have found that the Fed's various asset purchase programs exert their impact on the bond market and financial conditions mainly through "stock" effects (see Sven Jari Stehn, "Stocks vs. Flows Revisited: End of QE2 Unlikely to Have Significant Effect on Bond Yields," US Daily, April 13, 2011). However, we empirically found some evidence that "flow" effects might be bigger at the very long end of the yield curve, although this was based on very few observations and not statistically significant. If there is a meaningful flow effect, the end of Operation Twist in June may trigger a tightening of financial conditions if it is not followed by another asset purchase program.
Q: But wouldn't QE3 be inconsistent with the Fed's observed reaction function over the past few years?
A: At some level yes. At least until recently, the threshold for unconventional monetary easing appeared to be quite high. Back in 2010, the move toward QE2 didn't start until inflation had fallen far below the (then implicit) 2% target and at least some signs had appeared that the recovery might be starting to falter. And Operation Twist only got underway when, once again, Fed officials worried about the sustainability of the recovery in the wake of the deepening European crisis.
However, we believe that there has been a change in the reaction function in a more "dovish" direction more recently. At the January 25 FOMC press conference, Chairman Bernanke seemed to indicate a materially lower threshold for additional easing when he said that he saw a "very strong case" for more easing if the economy evolved in line with the SEP projections--which projected neither a large inflation undershoot nor a growth slowdown.
Admittedly, Bernanke has not repeated these comments since then, specifically in his Monetary Policy Testimony two weeks ago. This could mean that he has changed his mind in light of the generally stronger-than-expected data--or perhaps more precisely, that he no longer thinks the economy is evolving in line with the SEP projections. But it could also mean that he is merely reluctant to lay his cards on the table at a time when the committee as a whole is still debating the pros and cons of additional easing.
Q: The bond market has sold off sharply in the wake of the March 13 FOMC statement, as market participants have apparently scaled back their QE3 expectations. Was this justified?
A: We think not. At least compared to our own expectations, the statement was unsurprising. At the margin, the upgrade to the Fed's growth expectations was a bit more pronounced than we had expected, but this was offset by the fact that the softening of the sentence about "significant downside risks" was a bit less pronounced. Meanwhile, the recognition of upside near-term inflation risks was unsurprising given the increase in oil and gasoline prices. Admittedly, it is hard to know what type of statement the market had expected; unlike for economic data releases, there is no easily observable "consensus" for FOMC statements. But we do not believe that our expectations were so far from the market's view that the statement should have been a significant surprise.
Q: What does "sterilization" of QE mean, and is it important?
A: "Sterilization" of QE means that the Federal Reserve purchases assets (agency mortgage-backed securities and/or Treasuries) from a bank by crediting the bank's reserve accounts but then "drains" the resulting increase in excess bank reserves and the monetary base via reverse repurchase operations or by persuading the bank to tie up its assets for a somewhat longer period in a "term deposit."
We do not believe that there is a meaningful economic difference between "unsterilized" and "sterilized" QE. At the zero bound for nominal short-term interest rates, bank reserves are near-perfect substitutes for other safe short-term assets. In the pre-2008 world where the Fed was prohibited from paying interest on excess reserves (IOER), this near-perfect substitutability would have ended as soon as the Fed had wanted to move the funds rate away from zero, because an excess supply of reserves would then have "pinned" the funds rate to zero. Now, however, the Fed has the option of lifting the funds rate even in the presence of excess reserves by lifting the IOER. This means that bank reserves and very short-term assets such as term deposits are near-perfect substitutes even away from the zero bound.
Q: Would the Fed sterilize the impact of any additional quantitative easing?
A: We think so but are uncertain. The argument for sterilization is that it may be a low-cost way to overcome the widespread public discomfort with the notion that the Fed "prints money" (adds bank reserves) to buy assets. It is noteworthy that neither the bond purchases of the European Central Bank (which have generally been sterilized) nor the Fed's Operation Twist (which involves expansion of neither the Fed's balance sheet nor the monetary base) have generated as much worry about inflation as the Fed's QE2 program. Moreover, if a subset of investors believe--wrongly, in our view--that there is a difference between "printing money" and sterilized QE, they might push up commodity prices in response to an unsterilized QE announcement, which could lessen the policy's effectiveness. Why not avoid this by stating clearly that the asset purchases will not result in an increase in the monetary base?
The counterarguments are twofold. First, it might require Fed officials to explain why they didn’t sterilize in the early days of quantitative easing, and might even indicate a little more sensitivity to public and political pressure than the Fed likes to admit. Second, it could put some upward pressure on short-term interest rates because the Fed would need to induce investors to tie up their money for a bit longer. (However, if desired the Fed could overcome this by cutting the IOER.) Overall, we believe it is a close call, but think that sterilized QE is a bit more likely than unsterilized QE. We emphasize that the macroeconomic significance of this decision is minor.