The key focus of the coming week in financial markets will be the speech of Fed chairman Ben Bernanke at the Jackson Hole conference on Friday. Last year, the same speech was taken as confirmation that the Fed intended to embark on QE2, and this eventually triggered a 30 per cent rise in risk assets over the next six months. With the economy still weakening, the Fed is once again in easing mode, and some in the markets are hoping for another full dose of QE. They are likely to get something rather different.
The Fed chairman is in very difficult territory. The official Fed view has been that the recent slowdown in US growth will prove in part temporary and in part permanent. However, there is as yet no indication of the anticipated recovery in growth, and some indicators – such as the Philly Fed, and the consumer confidence indicators for August – seem consistent with an impending recession. Leading economic forecasters in the financial markets now say that there is a 33-40 per cent chance that the economy is already in recession.
Despite these downside risks, there has clearly been no consensus on the FOMC that further dramatic action to ease monetary policy is desirable. The inflation rate, in contrast to last year, has been somewhat elevated. Although most FOMC members seem confident that this is a temporary aberration, they are not yet ready to bet heavily on this.
Another factor at work is that several members of the FOMC believe that there are limits to what monetary policy can do to restore growth in the economy. This is not limited to the hawks like Charles Plosser. Even Chairman Bernanke himself has said that expectations about the effectiveness of QE should not be exaggerated. According to the Chairman, QE has worked as intended in a directional sense, but the overall impact has been moderate in scale. He does not explain why, in that case, the policy has not been increased in size.
When Japan fell into a deflationary trap about a decade ago, Mr Bernanke was of course the most outspoken member of the FOMC in arguing that the limits to the effectiveness of Bank of Japan policy were self-imposed. He laid out a full menu of options, ranging from QE-type government bond purchases, to the buying of equities and foreign assets, which he claimed would assuredly stimulate the economy. It was only institutional fragility, he said, which prevented these options from being used.
At a recent press conference, Mr Bernanke was asked whether he had changed this view and, if so, why? His answer implied that he still believed in his original economic analysis, but as a result of his experience as a central banker, he now accepted that there were institutional limits on the BoJ’s realistic scope for action.
There is no evidence that Mr Bernanke believes that the US has yet encountered a deflationary trap which is as severe as that which faced Japan in 2001-03. In fact, he seems to think that the economy has moved in the opposite direction in the past year, with deflationary risks receding. However, looking beyond recent inflation statistics, there are clearly other symptoms which suggest that the US is facing “Japanification”, in particular the slowdown seen in economic growth as soon as fiscal support has been removed.
But even if Mr Bernanke did think that the Fed should act in the dramatic way he prescribed for Japan a decade ago, it is not clear that he could gain institutional support for this course of action. The Fed has no power to buy equities, for example, and could only buy foreign securities (to drive down the dollar) with the support of the Treasury.
In addition, the political mood in Washington does not seem ready to support a further round of QE. Republican presidential candidate Rick Perry has said that further printing of money would be treasonable, and that treason is a capital offence. This sort of language must be extremely depressing for the cerebral Mr Bernanke to hear, but he also knows that he cannot entirely ignore it.
Another full dose of QE therefore seems unlikely. But nor does it seem likely that the Fed chairman will leave the markets entirely without support on Friday. So what might he say?
The leading candidate, according to many Fed watchers, is that the chairman might talk about extending the duration of the Fed’s portfolio of bond holdings, in effect replacing some of its holdings of short dated bonds with larger purchases of longer dated bonds. This would be intended to reduce longer dated Treasury yields, thus stimulating the economy without creating the political flak which would follow from a further increase in the absolute size of the Fed’s balance sheet.
This would be a repeat of “Operation Twist” which was undertaken by the Fed and Treasury from 1961-63, when the Kennedy administration wanted to ease monetary policy without cutting short term interest rates. Short rates needed to stay high to support the dollar’s exchange rate, which was fixed under the Bretton Woods system at the time.
Most economists believe that Operation Twist had relatively little impact on the economy. A recent study by the San Francisco Fed concluded that the size of the operation, relative to the then size of the Treasury market, was about two thirds as big as QE2, and that it cut Treasury yields by only about 15 basis points.
In present circumstances, that might seem to most investors to be little more than a drop in the bucket.
Related reading:
The week ahead in central banking – FT Money Supply blog
