After Jackson Hole, Clear Road Ahead?

In terms of forward guidance I think the Fed Chairman's speech provided little direction, but Friday's precious metal price action into the close and the various sell side notes that I have seen suggest that this, at least initially, is too bearish a conclusion. The following excerpt from the speech, in particular, was taken as clear evidence of more and aggressive easing in the pipeline. 

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

Great emphasis has been attached to the chairman's use of the word "grave" as a clear tell-tell sign of more easing to come. I find this quite interesting since it is one of the first instances of such "new speak" interpretation of the Fed's statements akin to the good old days of Trichet and the utterance of (strong) vigilance. Needless to say, next week's jobs market report has suddenly been propelled to a key market event and every single US data point will now be watched with caution. On that note, the next ISM reading as well as consumption figures will be equally important to watch. 

I think Tim Duy’s interpretation is the right one then (hat tip Calculated Risk) with my emphasis.

On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment points in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.

On balance the main point for me is that the recent change in economic data clearly merits policy change on the basis of the Fed's reaction function. 

The unemployment rate in the US is sticky and the Fed has been persistently concerned about this which is indeed a strong signal to the policy bias especially as inflation expectations are well behaved. Inflation has come down significantly in the US running at 1.4% YoY and the Taylor Rule rate is now declining (though still in level terms way above 0 but that has more to do with the inputs than anything else). We have had two consecutive months of sub-50 ISM readings and consumption growth appears to be rolling over. My interpretation of the forward looking indicators is that they look better than the consensus suggests, but the Fed lives in the here and now and will act accordingly.

Another interesting point here is that despite the visible and strong recovery in the growth rates of US housing market indicators, Bernanke mentions the level of the housing market and not the change which suggest that the despite a good run of data with respect to the change in housing market indicators the level is still seen as depressed. 

The bottom line is that some form of easing is coming but what I find highly uncertain is the timing and aggressiveness of such easing. The August minutes had already stipulated potential moves for the Fed in the form of an extension of the low interest rate commitment, lowering interest rates on excess reserves as well as an extension of Operation Twist or outright asset purchases (probably through MBS securities). But which of these measures will be employed and in what order?

One thing for example which I find very interesting is the glaring gap between Bernanke's discussion of the effectiveness of unconventional monetary policy and its effect on the real economy (i.e. labour market). In that sense, it seems quite clear to me that quantitative easing can have a strong effect in the context of imminent deflation risks and strong downward pressures in asset prices. In such an environment the portfolio effect and, indeed, outright price effect from aggressive central bank action can be very effective. 

However, whether quantitative easing can be effective in countering a structural and sticky unemployment rate (and indeed a structurally declining labour force participation rate) seems much more uncertain to me. Obviously, this goes back to the point that the Fed is the wrong tool for the job at hand, but it also raises the issue of what kind of easing the Fed is planning here.

Of the measures mentioned above one of the only things which would have an effect on the labour market (from a theoretical point of view) is an extension of the low interest rate commitment. This would be a signal to companies that their cost of capital would remain low and incentivise investment and thus, in theory, additional labour input. But such a process is slow and arguably a weak remedy in the context of structural labour market issues.

More generally, we must ask ourselves whether an extension of the low interest rate commitment be enough for the market Clearly not and in any case, an extension much beyond Bernanke’s term would be meaningless as the looming presidential election has created uncertainty as to how strong this commitment is, if for example Bernanke is faced with a Republican president.

What about an extension of Operation Twist then? If this is combined with an expansion of the balance sheet through purchases of MBS I think this could be an effective medicine (although in general I find it hard to see how it could meaningfully affect the labour market). However, the theoretical argument here is fair. By influencing long rates the Fed is likely to stand the greatest chance of supporting the ongoing recovery in the housing market and thus, by derivative, the US economy. 

Ultimately, I see two sources of uncertainty here. Firstly, it is not clear to me that the US economy is heading into a hole in the second half of 2012 to an extent that would allow very strong Fed action. Secondly, while the Fed clearly seems committed and perhaps even pre-committed to more easing the nature of such easing and its scope is still very uncertain to me. The upside risk attached to much stronger easing is clearly there (not least because we also have the ECB coming in with policy measures soon), but the spectre of grave disappointment has not been completely extinguished in my view. 

The Case of the Disappearing Bid?

I should immediately reassure my readers that I am not going to re-account or even continue Macro Man's story of 2007 in which Sherlock Holmes was looking for a vanishing bid in risky assets. Also, I am not sure that we are actually looking at a bid which will vanish but one which will perhaps taper off gradually or so at least is the estimated scenario policy makers would like markets to believe in. Of course, recent messages from the BOJ suggested a very cautious stance towards the economic outlook and although the ECB's chairman Trichet has ardently argued that an exit strategy from extraordinary financing provisions, the statement that, now is not the time to exit, still echoes most of the official messages coming from the ECB.

But perhaps more important than when to exit is the question of how and whether indeed it will be so easy and simple for central banks to simply wind down the supply of medicine. In the context of the ECB for example, I remain rather sceptical.

However, this day is all about the Fed decision  and although I only rarely delve into account of US monetary policy decisions (comparative advantage you know!) this one is important since it was always going to be parsed very closely for signs of hawkishness on rates on the one side as well as indications of the future wind down of asset purchases. Now, for those who expected a big bang, I have to side with Macro Man that it seems to be much ado about nothing in the sense that the Fed basically reiterated the general view that although economic activity had been showing positive signs lately and especially in the context of leading indicators pointing to a strong bounce in Q3 and Q4 activity, the fundamentals of very low capacity utilisation and deleveraging across the real economy remain intact. In the context of Fed speak this translates into maintaining the current rate target at the zero bound and the the forward looking statement that rates are to kept low for an extended period; 

Conditions in financial markets have improved further, and activity in the housing sector has increased.  Household spending seems to be stabilizing, but remains constrained by ongoing job losses, sluggish income growth, lower housing wealth, and tight credit.  Businesses are still cutting back on fixed investment and staffing, though at a slower pace; they continue to make progress in bringing inventory stocks into better alignment with sales.  Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.

With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability.  The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

So far so good then and this was really all we needed, one would imagine, to extent the rally in risky assets as well as the downward trend in the USD as the new funding currency for carry traders and others of their ilk. So far, there has been no signs of panic anywhere and everything seems to be all engines go.

Meanwhile, the Fed did actually give away some details as to how the future bout of asset purchases are to be conducted. On the matter of treasury purchases the Fed will its total purchase of $300 billion by the end of October. Most of us would naturally like to be able to predict what this will to do yields and prices and really you could spin this two ways. In the context of supply side worries, the Fed's withdrawal from the treasury market should push down yields if we add the, perhaps dubious assumption, that the $300 billion worth of supply of treasury bills has only been there to the extent that the Fed has been the main bidder (Say's law and everything). On the other hand it could also push up yields in a world where one assumes that there has been a decisive need to issue such bills and now that the Fed is stepping aside new buyers must step in and notwithstanding those with a printing press of their own, it should push up yields. Although this may seem quite innocuous and technical (i.e. unimportant) it may turn out to be important in a general context when it comes to the ability of economies (not just the US) to lift themselves out of the mire without the crutches of stimulus to lean on.

In the context of the Fed's outright asset purchases, the statement delivered good news for bulls/doves in so far as goes the fact that although the Fed was invariably going to issue a deadline, it seems to have been pushed somewhat out in the distance; well, at least a quarter. Consequently, the Fed will buy $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency debt, purchases which are set to be concluded by the end of the first quarter and not by year end which was the final date I had been led to believe judged by the points made in various economics report digested over the last week.

So, it is here perhaps that we may be looking at a disappearing bid in the context of the Fed gradually but surely reducing its presence in the market for MBS turds not to mention the agency market which went belly up as Fannie and Freddie crashed and burned. In the nice soothing light of efficient markets it is difficult to expect the decision to wind down purchases to be a big market mover as long as the incoming bout of data continues to provide plenty of upside and no downside. But if we get a setback just around the time when the Fed had envisioned to stand down its most aggressive measures of QE, one finds it difficult not to expect general sentiment and thus, in a forward looking perspective, real economic activity to take a hit which is exactly what we would all like to avoid; the double dip recession or "WL" recession if you will.

Ultimately, it is of course all still a great big mess, something which was neatly conveyed by the way Bloomberg handled the message carried by the IMF envoy to the G20 summit. On the one hand, the IMF was quoted for urging central banks to map a viable and transparent exit strategy and on the other hand Managing Director Dominique Strauss-Kahn was quoting for urging policy makers to not withdraw fiscal stimulus to quickly. Lost in translation are we?

Well, I am perhaps being unfair here to the editors of Bloomberg not to mention the IMF in particular since ultimately; talking about exit strategies is not the same thing as enforcing them. However, I do feel rather strongly about the need to make the following point that the two are of course intimately connected and withdrawing QE cannot but affect the trajectory of fiscal stimulus. This is a point which I believe for example is absolutely crucial to understand in the context of the Eurozone where the ECB's refinancing operations seem to be implicitly underpinning national governments' efforts to shore up their capsized economies.

In this context and assuming that both the BOJ and the ECB will be trailing the Fed somewhat, it will be most interesting to see whether Bernanke manages withdraw the bid on financial markets currently offered by the Fed's policies and indeed whether others may follow in his footsteps and withdraw theirs.