Q&A On QE With GS

Jan Hatzius, who has been spot on in every prediction so far this year, provides the following rhetorical Q&A on what is now a definitive QE2 announcement in less than 30 days (and if one doesn't come, the mid-term elections will be accompanied by a whole host of flash crashes). In a nutshell: "we continue to believe that these purchases will ultimately involve at least $1trn, possibly quite a lot more...more importantly, QE2 works on other elements of financial conditions, including equity prices and the exchange rate." In other words, look for gasoline at $10 at a gas station near you within 6 months, promptly to be followed by complete economic collapse and a 25% chance of revolution on the side.

From Goldman's Jan Hatzius

Q&A2 on QE2

We see Friday’s speech by William Dudley, president of the New York Federal Reserve Bank, as a strong signal that the FOMC is likely to announce another round of asset purchases at the November 2-3 meeting.   Although the initial amount is apt to be $500 billion (bn), most likely in longer-term Treasury securities, we continue to think that the program will cumulate to more at least $1 trillion (trn), possibly much more.  In this comment we reiterate and update our views on this issue, again in Q&A format.

Three weeks ago we published a daily comment, in Q&A format, reiterating our expectation for a second round of quantitative easing, commonly referred to as “QE2.”  (See Jan Hatzius, “Q&A on QE2,” US Daily Comment, September 14, 2010.)  In that comment we reaffirmed our view that QE2 was likely to occur sometime before the end of the first quarter of 2011, most likely via additional purchases at least $1trn of longer-term Treasuries (defined by the FOMC as having maturities of two years or more).  Since then, the September 21 FOMC statement and last Friday’s speech by William Dudley, president of the New York Federal Reserve Bank, have boosted our assessment of the probability that the FOMC will announce asset purchases at the conclusion of its next meeting, on November 3.  In this comment we amplify on this judgment, again in Q&A format.  (For the Dudley speech, see http://www.newyorkfed.org/newsevents/speeches/2010/dud101001.html.)

Q:   Why is the Dudley speech so important?  Didn’t he say these were just his views and not necessarily those of his colleagues?

He did say that, as all FOMC members do when they give speeches.  However, as Vice Chairman of the FOMC, he is one of the three most senior members of the committee.  As such, he would be highly unlikely to give a speech of this significance without the concurrence of Chairman Bernanke and probably other key members of the committee.  This does not mean that all 17 members, voting or otherwise, are in agreement, but it does strongly suggest that there is sufficient support for additional asset purchases to make it a serious option at the next meeting.

More importantly, President Dudley made it clear that current conditions are unacceptable insofar as the committee’s meeting its dual mandate is concerned.  The clearest statement occurred at the very outset, even before he noted that “what I am going to say [emphasis ours] reflects my own views and does not necessarily reflect the views of the Federal Open Market Committee and the Federal Reserve System”:

“Viewed through the lens of the Federal Reserve’s dual mandate—the pursuit of the highest level of employment consistent with price stability, the current situation is wholly unsatisfactory. Given the outlook that the upturn appears likely to strengthen only gradually, it will likely be several years before employment and inflation return to levels consistent with the Federal Reserve’s dual mandate.”

In other words, QE2 does not depend on conditions getting worse, meaning further increases in unemployment or further declines in inflation.  At least in Mr. Dudley’s view, conditions have to improve to justify the FOMC’s not easing policy further.  In this regard, three aspects of the quotation are noteworthy: (a) language that is uncharacteristically direct language for a Fed speech, (b) the focus on the Fed’s mandate, which has figured prominently in recent Fed communications, and (c) the length of time he thinks it will take to achieve that mandate, a point with which we thoroughly agree.

Q:   How likely is an announcement of asset purchases in November, and how has this probability changed in recent weeks?

An announcement to this effect is quite likely.  All along, the November meeting has seemed like the first genuine opportunity for the FOMC to make this move considering that that the panel was still focused on the exit strategy in late June and that the meetings in August and September were both one-day affairs, which limited the opportunity for extended debate.  Also, updated forecasts will be released at this meeting, making it somewhat more likely than other sessions.  At the beginning of August we thought it might take longer than until November to build a consensus for more asset purchases given that (a) most members of the FOMC have had a more optimistic view of growth than we have and (b) several members appeared to harbor significant reservations about further balance-sheet expansion.  However, after seeing the September 21 statement, we said action at the November 2-3 meeting was a “strong possibility.  It now looks even more likely, for the reasons already noted.

Q:   What would you have to see to make asset purchases unlikely in November?

Questions like this are always hard to answer in a specific way, as one can always imagine any number of events that could put the committee off, improbable though they might be.  However, when we consider that Fed officials were willing to put this message out more than a month before the next FOMC meeting, knowing that markets would price in” asset purchases beginning at that session, their intent to proceed must also be fairly robust to any upside surprises in the economic data between now and then.  We therefore think a pattern of exceptionally strong data, not fluky and not confined to one report, would be needed to push the decision off.  Even then, asset purchases would still have a large probability of occurring in subsequent months.

Q:   How big will the operation be, and how will it be packaged—all up front or in pieces?

In his speech, President Dudley said “some simple calculations based on recent experience suggest that “$500 billion of purchases would provide about as much stimulus as a reduction in the federal funds rate of between half a point and three quarters of a point,” noting quickly that this estimate was “sensitive to how long market participants expected the Fed to hold on to these assets” and to market confidence in the Fed’s “ability to exit when the time is right…”  In our view, this passage is important in two respects.

First, his mention of a specific figure suggests that this is an amount currently under consideration as an opening round.  While that might ultimately change, Fed officials would surely be aware that markets would be disappointed with a smaller figure.  Hence, any departure from this amount is more likely to be up given that a favorable market response to the announcement is instrumental to its success.

Second, by tying the choice of an amount to the size of a conventional easing in the federal funds rate, Mr. Dudley provides the analytical underpinnings for comments former Fed Vice Chairman Donald Kohn made about a month ago, when he suggested in a New York Times interview that QE2 might proceed in more incremental steps than the original program.  Speaking today at a CFA Institute Fixed Income Management Conference in California, Brian Sack, Manager of the Fed’s System Open Market Account (SOMA), reinforced the idea that Fed officials see additional balance sheet expansion as a substitute for cuts in the federal funds rate that are not currently possible.  (See http://www.newyorkfed.org/newsevents/speeches/2010/sac101004.html.)

If the FOMC takes a more incremental approach than it did in late 2008/early 2009, as suggested by these various officials’ comments, then it follows that markets will not know right away how big the asset purchases in QE2 ultimately will be.  Thus, while $500bn sounds small compared to our expectation of “at least $1trn,” we continue to believe that these purchases will ultimately involve at least $1trn, possibly quite a lot more.  This expectation is already built into our outlook for the economy in 2011.  It is one reason why we anticipate a pickup in growth as the year wears on.  The forecast of $1trn in Treasury purchases is in addition to those resulting from reinvestment of repayments of principal on agency debt and mortgage-backed securities (MBS).

Q:   Doesn’t the incremental approach sacrifice the benefits of a larger market response to a “big bang” announcement?

We believe it does, as discussed in a daily comment in early September. (See Jari Stehn, “Big Bang vs. Small Steps: Thoughts on Designing QE2.” US Daily Comment, September 8, 2010.)   However, this may be the price necessary to achieve consensus in the FOMC.  Moreover, the sacrifice might end up being relatively small if markets extrapolate whatever patterns they see in the FOMC’s behavior.  Against other uncertainties, notably whether the next round of asset purchases will have the same impact per dollar that is implied by current estimates based on QE1, this difference is probably small.  We will have more to say in upcoming research about quantifying the effects of asset purchases on interest rates in particular and financial conditions in general.

Q:   Will the asset purchases in QE2 be in Treasury securities or are more MBS purchases possible?

We continue to think that the purchases will be in longer-term Treasuries, at least initially.  However, recent Fed commentary has left the door open, at least implicitly, to a resumption of MBS purchases at some point.  For example, in discussing its reinvestment policy, the September 21 FOMC statement noted simply that “[t]he Committee also will maintain its existing policy of reinvesting principal payments from its securities holdings,” whereas the August 10 statement said: “[t]he Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.”  Of course, the earlier statement made reinvestment into Treasuries the “existing policy,” but the fact that Treasuries are not specifically mentioned might suggest an increased willingness to redirect those reinvestments toward MBS.  More recently, President Dudley’s speech outlined “purchasing medium and long-term Treasuries or agency mortgage-backed securities,” as one of the Fed’s expansionary tools without elevating one over the other, either there or elsewhere in the speech.

Q:   What can the Fed hope to accomplish when the demand for credit is so weak and spreads already so low?

This is the most common question we field regarding QE2.  Most observers see the likely impact on long-term rates as low, especially as markets already price in a significant probability of asset purchases.  They also question how much additional borrowing will occur in an environment where credit standards have tightened and households are deleveraging.

These are legitimate concerns, but they do not mean QE2 will not have an effect.  As President Dudley pointed out, those who are able to borrow will do so at lower rates, freeing up some of the income now being spent on debt service.  Perhaps more importantly, QE2 works on other elements of financial conditions, including equity prices and the exchange rate.  To the extent these moves bolster consumer confidence, reducing the drive to boost saving, and make US goods more competitive in world markets, QE2 can work through channels other than credit.

Q:   What options besides renewed asset purchases does the Fed have?

The main alternatives are to modify its communication with the markets and to tinker with its inflation objectives.  Recent speeches by Fed officials have offered some ideas for consideration on both fronts.  On communication, he suggested that the FOMC could be more explicit in saying how it planned to respond to shortfalls in meeting its objectives for inflation and unemployment.  On tinkering with its inflation objectives (this is our term—decidedly not his!), he suggested that the Fed could, in essence, target the price level over the medium term.  Thus, if inflation continued to fall short, then the FOMC would explicitly try to offset that with higher inflation later.

Most observers probably think of the Fed’s commitment to keep the federal funds rate at “exceptionally low levels…for an extended period” when they think of communication.  In this regard, the committee has already taken a significant step toward QE2 in our view, though not one that has been widely recognized in market chatter.  In particular, by saying explicitly that inflation is too low relative to its mandate, we believe that the FOMC has effectively defined “extended period” to be a lot longer than many probably assume.  After all, even if one assumes that they can successfully raise short-term rates before shrinking the balance sheet, why would they start to do so when inflation is too low?  In this regard, an observation toward the beginning of Mr. Sack’s speech is noteworthy:

“Indeed, according to their most recently published forecasts, most FOMC members expect the unemployment rate to remain above 8.25 percent through 2011 and the inflation rate to remain below its mandate-consistent level through 2012. In addition, the economy remains vulnerable to downside surprises that could take both output and inflation further away from the FOMC’s objectives.”

Now, Mr. Sack doesn’t sit on the FOMC, and he doesn’t speak for the committee either.  But he does make a valid point about the likely behavior of inflation over the next two to three years.  If the committee already sees inflation as too low through 2011 at a minimum, and unemployment at a level that is clearly too high, then why won’t that extended period extend well into 2012, if not beyond?