The US employment numbers for May seemed to surprise the markets, but in fact they confirmed what we already knew from a string of earlier data releases, which is that the economy has slowed very markedly in recent months. The debate now is whether this slowdown has been triggered mainly by transitory factors – the fallout from the Japanese earthquake, stormy weather, and a spike in gasoline prices above $4/gallon – or whether it reflects a more fundamental malaise in the economic recovery.
The equity markets have remained fairly upbeat about this, and most economists are still strongly of the view that this is just another mid-cycle slowdown of the sort which occurred last year. This still seems to be the most probable outcome (as I will argue here on Sunday). But what if this optimism is wrong? Is there a Plan B?
I am not usually disposed towards pessimistic nightmares about the US economy, but I am worried about the all-too-easy assumption, which is often heard from investors, that the Fed will automatically ride to the rescue if there are signs of a double dip recession. In fact, I have been told several times this week that QE3 is already a “done deal”, and that investors should already be buying gold and equities in advance of the same type of rally which was triggered by Federal Reserve chairman Ben Bernanke’s Jackson Hole speech last August. According to this “bad news is good news” school, the economic slowdown is the necessary prerequisite for the next leg up in the Fed-induced bull market.
I wonder. Is the Fed really ready to contemplate another vast expansion of its balance sheet, so soon after announcing a definitive end to QE2? There has been no indication whatsoever from any Fed source, even the most convinced doves, that anything like this is in the works. The main tenor of what the doves have been saying, at least in public, is that the economic recovery is strengthening and becoming more firmly based, though with continuing downside risks. (See this speech by Bill Dudley, for example.)
Meanwhile, the hawks are not budging from their belief that monetary policy should soon be tightened, not eased. Richard Fisher of the Dallas Fed said in an interview with the Wall Street Journal this week that the Fed had “done its job” and that any further stimulus would need to come from “someplace else”. Admittedly, Mr Fisher was a hawk even about QE2, but he represents a phalanx of Fed officials who would now actively dissent from any further increase in the central bank’s balance sheet. Last year, this group was willing to acquiesce silently when the Fed’s leadership opted for QE2.
Furthermore, the political backdrop within which the Fed is operating has clearly changed since last summer. Not only have Fed critics in Washington become much more vocal since the midterm elections, but the actual experience of what happened to the economy during the last phase of quantitative easing has given ammunition to the Fed’s opponents. This is a point emphasised in an email to me this week by my friend John Makin, a Resident Scholar at the AEI. This is what he said:
What good would QE3 do? If QE2 hasn’t boosted growth – even with the help of fiscal stimulus which is going away - why should QE3 do anything but boost inflation? Putting it another way, if printing money boosts growth and cuts unemployment, why not have perpetual high growth and low unemployment? QE is a reactive measure to contain deflation – that was the fundamental rationale for the strong hints of QE2 at Jackson Hole. As a proactive measure to boost growth, QE only produces temporary positive effects at best.
Many people in policy circles are going to be asking exactly these questions of Mr Bernanke if he tries to gather support for QE3. The Fed itself has done many studies which show that QE has had very similar effects to more conventional forms of monetary easing, but the evidence of the past 6 months has made many people sceptical about this comforting conclusion. Since QE2 was launched, real GDP growth has slowed markedly, while inflation and commodity prices have risen. Rightly or wrongly, another dose of the same medicine would certainly be a hard political sell.
And that is the source of my nightmare. If the present downward momentum in the economy were (unexpectedly) to continue, where would the rescue come from? With the Republicans in charge of the House, another fiscal stimulus seems improbable, to say the least. And even Mr Bernanke, who is clearly able to read the political tea leaves, has said that the hurdle to more Fed easing is “very high”. In these circumstances, the markets might suddenly conclude that the US cavalry is “out of ammo”.
Eventually, there would probably be a policy response, but not before the markets forced one.
