No QE3? Really? Oh yes, Zero Hedge 1, Goldman Sachs (who can possibly forget Goldman's shark jumping "New US Golden Age" report from December after all it took was one bad NFP print for Goldman to launch QE2 back in August?) 0 (here and here)
Just out from Jan Hatzius
1. With the first quarter now behind us, we have downgraded our Q1 GDP estimate to 2.5% from 3.5%. By itself, that’s not a big deal. Most indicators other than those that happen to go into the GDP bean count—in particular, virtually all business surveys and labor market indicators—continue to look solid and are probably a more accurate guide to the economy’s true strength. We believe that first-quarter GDP was held down by temporary factors, including poor weather and perhaps a bad draw from noisy data. Because temporary factors must eventually reverse by definition, this could mean a very strong quarterly GDP reading in Q2 (we are at 4%).
2. But the risks to our second-half GDP forecast of 4% also remain on the downside, and that’s more meaningful. We don’t see anything dramatic at this point, just a few weaker signals here and there. Gasoline prices are making new highs again, fiscal policy is starting to tighten a bit more aggressively, and a couple of indicators—specifically ISM new orders and consumer expectations—have softened a bit. So H2 is on downgrade watch.
3. The inflation news is also a thorn in our side. We still think the pass-through from commodity prices into core inflation will be very limited, and there is still a large amount of slack even after the 1-percentage-point drop in the unemployment rate over the past four months. But the core inflation data has clearly been a little firmer than we thought, with rent and owners’ equivalent rent leading the way. At some level, this sounds a bit odd because it’s hard to believe that the battered housing sector is a genuine source of upside inflation risk. Nevertheless, the risks to our forecast that core inflation will stay at 1% are on the upside.
4. Some Fed officials have reacted to the firmer inflation numbers by slightly hedging their earlier calls for continued accommodation, emphasizing that significant second-round effects and higher inflation expectations would not be tolerated, and implying that monetary policy may need to be tightened a bit earlier than they had thought a few months ago. We share this view; given the recent data, the risks are skewed toward a somewhat earlier date for the first rate hike than our current forecast of 2013Q1.
5. But other Fed officials go far beyond this and sound a lot more concerned about the possibility of an inflationary outbreak. There is now a serious split on the FOMC. We believe that the split partly boils down to a disagreement about the significance of the monetary base (currency plus bank reserves held with the Fed). The base has tripled from $800 billion before the crisis to $2.4 trillion now, mostly because of a huge increase in excess bank reserves in the wake of the Fed’s large-scale asset purchase program. Some Fed officials, as well as many investors, believe that the increase in the base represents a large inflationary potential, over and above the factors emphasized by the FOMC majority such as GDP, employment, wages, capacity utilization, and input costs. Thus, they take any acceleration in inflation or inflation expectations as a potential signal that the dreaded day has arrived, at a time when the Fed is still “feeding the fire” by continuing to buy Treasuries.
6. Some of this particular concern may be rooted in the traditional money multiplier theory, which holds that the availability of bank reserves is the key constraint on bank lending. It implies that banks will eventually “use” the excess reserves to make significantly more loans. This, the story goes, will lead to a sharp increase in credit creation and ultimately inflation.
7. We disagree with this story and so, we think, does the FOMC majority. [TD: which means this is guaranteed to occur] It stands and falls with the assumption that (bank) loans are financed by deposits subject to minimum reserve requirements, and are therefore “constrained” by the amount of reserves in the system. In reality, however, most bank loans have long been primarily funded from sources other than deposits subject to minimum reserve requirements, including nontransaction deposits, bonds, and commercial paper. This means that bank lending was not constrained by the availability of reserves even prior to the increase in excess reserves. Relieving a non-existent constraint cannot be important for credit creation or inflation. If so, the monetary base is essentially meaningless. (This does not mean that QE2 had no effect, but it does mean that the effect is much more limited and works through the impact of the Fed’s larger asset holdings on bond yields and financial conditions, not through the liability side of the Fed’s balance sheet and the monetary base.)
8. The upshot is that the growth news is a little worse, the inflation news is a little worse, and the risk that the Fed might tighten before early 2013 has gone up a little. None of this is dramatic, and we think the basic story of good growth, low inflation, and friendly monetary policy that we have been telling since late last year still stands. But it’s all a little messier than we would like.