The financial markets have now discounted some form of Fed easing at tomorrow’s FOMC meeting, and it seems to me unlikely that policy makers will allow these expectations to be completely dashed. If that were to happen, the setback to both bond and equity markets could be quite large, and the Fed will not want to risk this with economic data tending to weaken in recent weeks. However, the slowdown in the US economy has been fairly gradual, and bears no comparison with what happened when the economy fell off a cliff in late 2008. If the Fed makes any move, which I believe it will, then it will only be fairly minor this week. But it could signal a more significant shift later in the year.
The extent to which the bond markets have already discounted persistently easy policy by the Fed is shown in the first graph. The Fed funds rate has, of course, been unchanged for over a year, but longer term interest rates have been adjusting to the likelihood that these very low short rates will be in place for a much longer period than was assumed at the start of the year. (In theory, longer term rates are determined by the expected path for short rates, plus a risk premium; so if short rates are expected to stay lower for longer, then long rates fall.) Since the beginning of April, when optimism about the economic recovery was at its peak, 2-year bond yields have fallen by 0.63 per cent as the market has realised that the Fed would not tighten monetary policy until at least the end of 2011.
More remakarbly, the 5-year yield has dropped by 1.20 per cent, and the 10-year yield has tumbled 1.14 per cent, presumably reflecting a belief that abnormally low short rates will persist for many years to come. The decline in bond yields has flown directly in the face of expectations that bond yields would rise because of fears about excessive government deficits, in a pattern which is disturbingly similar to what happened when Japan headed towards deflation a decade ago.
I am certainly not suggesting that the Fed is facing a situation which is anywhere near as dire as they faced about 18 months ago. The second graph shows the “breakeven” inflation expectations which are priced into the bond market. After the collapse of Lehman Brothers, the markets became so panicked about the state of the economy that they priced in zero inflation for a full 10 years ahead.This time, the drop in inflation expectations has been really quite minor and controlled, suggesting that the Fed does not have to react with the type of emergency packages we saw when the credit crunch was at its peak.
So if the Fed decides that some moderate shift in its stance is all that is currently needed, what will it do? One option is to change the language in its statement to emphasise more clearly that it is willing to ease further if needed, or to say more explicitly that it will maintain exceptionally low rates for even longer than anticipated. The FOMC might hope that this will be reflected in a renewed drop in bond yields as markets push the first date of Fed tightening even further back into the dim and distant future.
An alternative would be to change its stance on quantitative easing, most probably by saying that it will not allow the size of its balance sheet to decline when its holding of mortgage debt mature over the balance of this year. This would not amount to more QE right now, but it would eliminate the expectation that the amount of QE will actually be reversed as the economy slows.
Last week, economists at Goldman Sachs released a study which estimated the degree to which quantitative easing on the one hand, and Fed language on the other, had reduced 10 year bond yields since the credit crunch started. They concluded that both of these arms of policy had had roughly the same effect, with each of them reducing bond yields by about half a percent, compared to what otherwise would have happened. (This study by economists at the St Louis Fed also suggests that QE has been effective in reducing bond yields in the US and elsewhere, reinforcing the conclusion that the Fed has not “run out of ammunition” just because the short term interest rate has hit rock bottom).
The Goldman Sachs economists reckon that adjustments in Fed language have just about reached the limit of their likely effectiveness, so they expect that the Fed is more likely to change its guidance on QE tomorrow, which certainly be a more dramatic shift in stance. But the Fed is not in emergency mode, and it may take them a little longer to get there.
Bruce Kasman at J.P.Morgan has recently pointed out that the Fed has eased at this stage of each of the past four economic cycles, in effect buying an insurance against the mid-cycle slowdown developing into a double dip recession. At tomorrow’s meeting, I expect them to signal that it is insurance time again.
Related reading:
Fed Watch: Waiting for nothing? Economist’s View
Chorus of QE calls is deafening FT Alphaville
Latest posts on the Fed FT Money Supply
