Probability Map: Morgan Stanley's Vincent Reinhart still says 75% chance of Fed QE3 by June

Newsflash: the Fed controls the economy. It's working on financial markets. Former Fed official and Treasury put-master Vincent Reinhart, who is now the chief U.S. economist at Morgan Stanley, says the only way QE3 doesn't happen is "if the economy surges or equity investors continue to embrace risk," in which case "the Fed would cheerfully keep its plans on the shelf." The only problem is it looks like we just had the "surge" and it didn't seem to impress the Federal Reserve, and every time they try to exit a buying program, the market tanks. Reinhart sees either a $500-700 billion round of QE3 or a second Operation Twist if they decide they want to act faster:

[OT2] could stretch purchases out until the end of the year, implying total new purchases of about $400 billion, and include MBS as well as Treasuries. OT2 would allow the Fed to act sooner, say at the March or April meeting, and frame the initiative as support for the ongoing economic expansion. It would also buy some insurance from criticism by keeping the overall size of the balance sheet unchanged.
In short:

 

Given Reinhart's CV, these comments on how the Fed is plainly ignoring the pickup in economic activity we've seen in the last quarter in the U.S. are incredibly suggestive:
Stronger incoming data have mostly been ignored by the Fed. There was almost no mention of favorable readings on activity and the labor market in the Fed’s public statements earlier this year. Only late in the game, with the semiannual testimony to Congress, did Chairman Bernanke devote much attention to employment gains. No doubt, it would have been awkward otherwise to review economic developments over the past year without noting that the unemployment rate has fallen 3/4 percentage point. Even so, the Chairman’s reminder that “...the job market remains far from normal...” seemed to be the main takeaway. The Fed either does not accept that the pickup in growth will be sustained or does not want market participants to get carried away in connecting the last few data points.
Morgan Stanley has been calling for a slowdown since the beginning of the year based on inventories data and unsustainable employment trends, which informs their QE3 call. Reinhart notes the Fed is actually seriously concerned about the effect the eurozone crisis will have on the United States:
Every Fed statement frets that “...strains in global financial markets posed significant downside risk to the economic outlook.” Deep down to their free-market bones, Fed officials are mostly Euro-skeptics who have trouble convincing themselves that a flawed currency union will survive. A general piece of advice from Fed economists working on the policy challenges posed by the zero bound to the nominal funds rate is that it is best to front-load policy accommodation if there is a significant risk of an adverse event. That way, the economy is on a stronger footing if the blow does strike. The political calendar makes this insurance motive more important: Since the Fed likely wants to keep a low profile during the height of the campaign season, it should be quicker to act in the first half in anticipation of adverse shocks.
Reinhart defends the QE3 call, mentioning some "off-kilter" objections that he has to shoot down literally "whenever we are asked them." These are "reasons we are not wrong."

1) Doesn’t the Fed need to see a fall in economic activity before it acts? Reinhart:
What matters is the explanation earlier in the minutes that is limited to the ten voters. There we learned that a few members thought current and prospective economic conditions could warrant action “before long.” Other members would support this if “...the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate...” In minutes math, a “few” plus “others” is likely a majority. Note that the first trigger only requires a slowing in economic expansion and that the second is already met in their published forecast.
2) Here is a good one: doesn’t the recent run-up in oil prices take Fed action off the table? Reinhart:
Chairman Bernanke’s academic work on the strong post-WWII association between energy price spikes and subsequent recessions puts part of the blame on the Fed’s historical response. As long as inflation expectations are well anchored, the strong conclusion is that the central bank should ease policy to counter the blow to aggregate demand. Thus, the recent rise in oil prices and the risk that they go higher likely inclines the Fed to do more, not less.
3) And finally, the world over: how can Fed officials believe that further balance-sheet manipulation would work? Reinhart:
It is their job. The Fed wants to be seen by the private and public sectors as willing to act when there is a need. For households and firms, QE3 or OT2 might boost confidence. For the rest of officialdom, the Fed would show that at least one institution in Washington DC retained a sense of purpose.
That's good, because they were starting to worry that the Fed hadn't "retained a sense of purpose" lately.

 

 

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