Previewing Bernanke's 10 AM Congressional Testimony

When it comes to insight into what is on Ben Bernanke, nobody is quite as capable as the firm that runs not only the NY Fed, but virtually every other central bank in the world: Goldman Sachs. Below we present Jan Hatzius' thoughts on what to expect when Bernanke takes the stand at 10 am today when he delivers the first day of his semi-annual Humphrey Hawkins presentation to Congress. Many expect him to hint at more QE, and lately a tempest in a teapot (to use the parlance of our times) has erupted over the possibility that the Fed will lower IOER to 0 or even negative. Here is what Goldman has to say about that: "we do not expect an IOER cut at this time." In fact, Goldman is rather skeptical Bernanke will hit at much if anything, especially with bond yields already at record lows: after all, how much more frontrunning of the Fed's bond or MBS purchases is there? Instead look for much more grilling on the Fed's role in Lieborgate: congress is now realizing it is woefully behind its UK political cousins when it comes to reaping points from years of global Libor manipulation. More importantly, Maxine et al have finally finished all those "Libor for absolute corrupt idiots" books they ordered almost a month ago so they are truly prepared.

From Goldman Sachs

Bernanke Preview

  • In Tuesday's testimony, we expect Fed Chairman Bernanke to deliver a dovish message regarding the committee's evaluation of the recent economic data and to provide at least a general discussion of further easing options.
  • At present, our own expectation is that the FOMC will extend the forward rate guidance further at the July 31-August 1 meeting, and to return to asset purchases in late 2012/early 2013. An earlier return to asset purchases is possible if the data continue to disappoint, but we do not think that the hurdle has yet been met. We do not expect a cut in the interest rate on excess reserves (IOER) or a credit easing program along the lines of the Bank of England's "funding for lending" scheme, although both may well come up in Tuesday's testimony.

Here are our expectations for Fed Chairman Bernanke's semiannual monetary policy testimony on Tuesday, June 17 at 10am EDT in Q&A form:

Q: What do you expect the chairman to say?

A: We expect him to deliver a dovish message as far as the economy is concerned, at the margin more dovish than in the June 20 FOMC statement. After all, the economic indicators have clearly disappointed expectations since then. Our estimate for Q2 real GDP growth currently stands at 1.1% (annualized), down from 1.6% on June 19. Our Current Activity Indicator (CAI) stands at 1.0% for June, down from 1.5% for May as reported on June 19. (The June reading is now 1.7%, i.e. there has been a small upward revision since June 19.)

Moreover, the chairman is likely to indicate that further easing remains an option. The June 20 FOMC statement noted that "…[t]he Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability." This is a clear "easing bias," which has probably been reinforced by the weakness in the recent data.

We would therefore expect the chairman to discuss the options for additional easing, at least in general terms. If he provides such a list, it would probably include, at a minimum, a further lengthening of the forward funds rate guidance and a return to asset purchases financed via an expansion of the balance sheet. It might also include other options, such as a cut in the interest rate on excess reserves (IOER), a credit easing program along the lines of the "funding for lending" scheme recently announced by the Bank of England, and perhaps other "new tools" for easing financial conditions (as desired by "several" participants at the June 19-20 FOMC meeting).

Q: Do you agree that further easing is likely?

A: Yes We currently expect a small easing step at the July 31-August 1 FOMC meeting, most likely a lengthening of the forward funds rate guidance from "late 2014" to "mid-2015." We also expect further purchases of long-term Treasuries and mortgage-backed securities financed via a return to balance sheet expansion, although our best guess for the timing of this move is late 2012 or early 2013.

Q: Might the FOMC already return to QE in August or September?

A: It's possible. But there are three reasons why our central expectation is that it will take longer. First, the chairman noted at the last press conference that the extension of Operation Twist--in a size substantially greater than expected by most forecasters in the "twist extension" camp prior to the meeting--was a "substantive" easing step and that unconventional easing steps "by their nature…tend to be lumpy." This would suggest that renewed balance sheet action is more likely at a time when the prior program expires, namely at the end of 2012 rather than in August or September.

Second, while the economic data suggest that additional easing is warranted, as noted above, financial conditions send a different message. Our GSFCI has generally eased in recent weeks and now stands at 99.97, back to the levels of early May before the most recent bout of market jitters about the European situation. Assuming financial conditions stay at current levels, our statistical model of meeting-by-meeting Fed policy currently says that the probability of an easing step at the next meeting is only around one-third (depending on the precise version of the model). We would not necessarily take the model as a literal guide, and we do expect a small easing step on August 1, but this does suggest that the relaxation in financial conditions is an argument against expecting a big step in the short term.

Third, the committee seems to view balance sheet expansion as more costly than other easing actions. This is partly because balance sheet expansion is controversial politically, which becomes more of an issue as the presidential election approaches. But it is also because the committee still sees a tail risk that further balance sheet expansion could unmoor inflation expectations and/or complicate the exit from the current policy stance. None of these arguments are absolute, but they do raise the hurdle to renewed balance sheet expansion a bit, in our view.

Q: Is the Fed likely to cut the interest rate on excess reserves (IOER)?

A: We would not rule it out entirely. The ECB's decision to reduce its marginal lending rate to zero seems to have had a modestly expansionary impact in Europe. Likewise, lower rates at the very short end of the US yield curve could have an expansionary impact by reducing banks' opportunity cost of making loans to private-sector borrowers. Moreover, a cut in the IOER is easier to communicate as an easing step than most of the unconventional measures deployed by Fed officials in recent years.

However, we do not expect an IOER cut at this time. There is still a concern that a very low or zero IOER could cause systemic problems in the financial system by increasing the pressure on money market mutual funds, and triggering a forced re-intermediation of funds through the banking system. Few such issues have surfaced in Europe in the wake of the ECB cut, but the MMMF industry is much bigger in the US than in Europe and hence inherently a bigger concern.

Moreover, from a practical forecasting perspective, we would note that the IOER issue has barely come up in Fed communications in recent months. It was clearly on the table in late 2011, but the FOMC seems to have decided that the substantial extension of the forward guidance is a superior way of holding down rates at the short end of the yield curve. If Chairman Bernanke raises the issue in his testimony on Tuesday, we would rethink the issue, but at this point an IOER cut is fairly low down on our list of easing options.

Q: What about a credit easing program along the lines of the Bank of England's "funding for lending" scheme?

A: This program may very well come up on Tuesday, either in the testimony or in the Q&A session. To recap, it offers low-cost term financing to banks against a wide range of collateral, with the objective of increasing their willingness and ability to lend. Although Chairman Bernanke said "we're very interested" in response to a question at the last press conference, we currently do not expect such a program in the US. First, unlike in the UK, it does not seem that the availability of bank funding is a significant restraint on bank lending. In fact, US banks are awash in low-cost deposit funding. While much of this is technically short-term rather than long-term funding, deposits are sufficiently "sticky" that banks can easily use them to finance long-term assets. So the benefit from a similar program in the US seems lower than in the UK. Second, one could argue that a BoE-style program veers into the realm of fiscal policy. The UK Treasury was involved in designing the program, although it provided no explicit funding to the Bank of England. Likewise, he Fed is likely to view any need for Treasury involvement as a drawback.