For today's preview of the FOMC rate decision (which should really be called a QE3 decision), we go to RanSquawk which highlights the push and pull mechanics of today's events, and to Goldman which once again makes the explicit clarification that it needs QE3 with the statement that "A bit more easing might be needed in the near term." Yes Goldie, we know you want another year of record bonuses.
PREVIEW: FOMC rate-decision due at 1915 BST (1315 CDT)
Today’s FOMC rate-decision comes in the backdrop of a long-term sovereign rating downgrade of the US by S&P to AA+ from AAA, with a negative outlook. The latest move by the S&P may force policymakers to debate the viability of further monetary easing, as the downgrade could see a rise in the long-term interest rates. Moreover, a sustained reaction from the present crisis could translate into a slowdown in growth, which together with sluggish personal income/spending in the US, and fading temporary factors supporting prices may weigh upon the country’s core inflation further, and in turn force the Fed to act. Although, in its latest communiqué, the Fed said that S&P’s ratings downgrade does not affect the operation of its emergency lending window or its buying and selling of Treasury securities to conduct monetary policy.
The Fed is likely to keep its “exceptionally low” borrowing cost for “an extended period” language, although it may be tempted to use the “extended period” phrase with respect to reinvesting principal payments. A more aggressive approach would be for the Fed to alter its reinvestment policy so as to extend the average maturity of its security portfolio, which currently stands at around 6.1 years. However, this is unlikely to be a favourable option as it may hinder a smooth exit from Fed’s current loose monetary policy. The Fed could signal another round of quantitative easing, although it would be reluctant to do so as this may raise questions about whether the Fed is simply monetising the US debt, which could undermine confidence in the USD and drive interest rates higher.
Some policymakers may opt to slash the interest paid on excess reserves and thus in effect encourage enhanced lending by the country’s financial institutions. However, in Bernanke’s own words, this approach would have little effect on overall financial conditions. A more desirable approach may be for the Fed to open a new lending facility to increase credit availability for targeted sectors of the economy those that need help. The Fed could reduce the secondary credit rate in its discount window or alternatively start to accept a wider range of collateral in exchange for loans offered. This may help the access of funds to a wider economy, and may prevent the danger of big institutions strengthening their own balance sheets as opposed to lending.
Bernanke has been a prominent supporter of an explicit inflation target, and it would be interesting to see any comments along these lines. By setting a higher inflation target the Fed can give itself more room for further monetary easing. Elsewhere, the Fed could lower its 2011 growth forecast for a third consecutive time, which currently stands at 2.7%-2.9%. It may also surprise the market by lowering its core PCE inflation target, which currently stands at 1.5%-1.8%, citing fading temporary factors supporting prices. In terms of market reaction, any indication of further easing would potentially see weakness in the USD, and is likely to support Treasuries and equities. However, if the Fed cuts its growth/inflation forecast, that may exert downward pressure on the currency and equities, and in turn support T-Notes.
It is also worth noting that the FOMC rate-decision is due at 1915 BST (1315 CDT) and there is no press-conference from Fed’s Bernanke following the rate-decision. According to the press-release by the Fed, dated March 24th 2011, the next press-conference by the Chairman will be on November 2nd 2011.
And here is Goldman which makes it 3rd consecutive push for QE3, saying "A bit more easing may be needed in the near term."
Last Friday we lowered our growth forecast further and now expect real GDP to increase just 2%-2½% (annualized) through the end of 2012. Since this pace is slightly below the US economy’s potential, we now expect the unemployment rate to be at 9¼% by the end of 2012. Given the large—and now growing—amount of slack in the economy, we expect the year-on-year rate of core inflation to fall from a peak of around 2% in late 2011 to 1¼% in late 2012. (For details see Jan Hatzius, "Subpar Growth Brings the Fed Back into Play," US Economics Analyst, 11/31.)
What are the implications of these forecast changes for the Fed outlook? Our preferred tool for thinking about this question is our forward-looking Taylor-type rule, which describes how Fed officials have historically set the funds rate using their four-quarter-ahead forecasts of core PCE inflation as well as the expected unemployment gap (actual less “structural” unemployment). (For details see Jan Hatzius and Sven Jari Stehn, “The "Warranted" Funds Rate: Is It Really Negative?” US Daily, March 10, 2010.) Moreover, we have constructed a "QE-adjusted" version of our Taylor rule to take into account the Fed’s unconventional policies—including its “extended period” language and its asset purchase programs (“QE1” and “QE2”). (For details see Jan Hatzius and Sven Jari Stehn,"QE2: How Much is Needed?" US Economics Analyst, October 22, 2010.)
Plugging our new forecasts into our Taylor rule has two implications for our Fed outlook (see exhibit below):
1. A bit more easing might be needed in the near term. Under our new forecasts our QE-adjusted Taylor rule implies that the “warranted” funds rate is currently -1.7%. (This figure is obtained by adjusting the funds rate implied by our baseline Taylor rule, -3.7%, with our estimate of the effectiveness of the Fed's unconventional policies, equal to 2%. For details, see US Economics Analyst, October 22, 2010.) Given a current funds rate of 0.1%, the "policy gap" between the actual and appropriate funds rate is therefore about 180 basis points. Does this gap mean that the Federal Open Market Committee (FOMC) will adopt a third round of quantitative easing? Our answer is “probably not”, unless the economy falls back into recession.
The reason is that the committee perceives asset purchases as cosiderably more costly than an equivalent amount of conventional monetary stimulus, and is therefore not likely to close this policy gap fully. Taking a view on the perceived costs of returning to unconventional easing--and thus on the threshold for the warranted funds rate below which Fed officials might adopt QE3--is difficult. Prior to QE2, we estimated that because of these costs the FOMC was willing to accept a gap between the warranted and actual policy stance worth 100bps in the funds rate. (See US Economics Analyst, October 22, 2010.) Given the backlash against QE2 since then, we believe that the threshold for further quantitative easing has risen, perhaps to something like 150bps.
Unless the economic outlook deteriorates further, we therefore expect that Fed officials will only take two small steps to close some of the policy gap. (Given a 150bp easing threshold, our calculations imply that they might close 30bp of the current 180bp policy gap.) First, we expect them to expand the scope of their “extended period” language to cover not only the exceptionally low funds rate but also the exceptionally large balance sheet. For example, they could rewrite the current forward-looking language in the statement to say that economic conditions “…are likely to warrant exceptionally low levels for the federal funds rate and exceptionally large asset holdings for an extended period” (our suggested change in italics). New York Fed estimates, for example, suggest that pushing out the expectation for the start of balance-sheet run-off by one year would narrow the policy gap by 25bp. We expect that this change will occur in tomorrow's FOMC meeting. Second, we expect the composition of the Fed’s balance sheet to shift toward longer maturities. This could happen via an increase in the average maturity of its reinvestment of MBS paydowns and/or a change in the reinvestment policy for its Treasury portfolio. Although such a change is possible tomorrow, we think it is more likely to occur at a later date.
2. The Fed is likely to exit even later. Our new forecasts reinforce our long-held call for no funds rate hikes until 2013, and suggest that it could be even later. Indeed, our Taylor rule suggests that it could be as long as late 2014 before the first funds rate hike becomes appropriate--around 18 months later than before. This prediction is close to that from a rule estimated by Glenn Rudebusch of the San Francisco Fed (see "The Fed's Exit Strategy for Monetary Policy," FRBSF Economic Letter, 2010-18). Feeding our new forecasts into his rule suggests that the first rate hike might take place in mid-2014.
Judging by the offerless surge in futures (at least for the time being), either we have a massive short squeeze on overnight positions, or someone has already selectively lifted the Fed embargo.