QE3 is on the cards

Fed wouldn?t normally be easing in today?s inflation climate but US economic conditions are worsening

Extension of Operation Twist by the US Fed certainly came as no surprise. The Fed had pretty much laid down the preconditions for easing monetary policy: a slowing labour market and deteriorating consumption. Everything Fed Chairman Bernanke warned about in the first quarter was coming to fruition, hence the decision on June 20, 2012 to further extend Operation Twist.

It is difficult to make a definitive pronouncement on the success of Operation Twist for lowering interest rates. Changes can be sudden in this global atmosphere of economic unrest, and the volatility in markets around the world is a bit nerve-racking. According to the Freddie Mac survey, the 30-year mortgage rate has fluctuated between 4.22% and 3.83% since the first week in September, but the most recent average is 3.71%, just fractionally off the all-time low of 3.67%. Graph 1 offers a snapshot of selected Treasury yields and the 30-year fixed mortgage (excluding points). At this point, the Fed seems to have had some success with Twist, but the extension suggests more serious financial illness than the initial prescription could relieve.

Initially the Fed Funds Rate (FFR) underwent a series of cuts, and with the collapse of Bear Stearns, the Fed launched a veritable alphabet soup of tactical strategies intended to stave off economic disaster: PDCF, TALF, TARP, etc. But shortly after the Lehman bankruptcy filing, the Fed really swung into high gear. The FFR fell off a cliff and soon bounced in the lower half of the 0-0.25% ZIRP (Zero Interest Rate Policy), now in its fourth year.

If a picture is worth a thousand words, graph 2 needs little additional explanation?except perhaps for those who are puzzled by the Jackson Hole callout. The reference is to Chairman Bernanke?s speech at the Fed?s 2010 annual symposium in Jackson Hole, Wyoming. Bernanke strongly hinted about the forthcoming Fed intervention that was subsequently initiated in November of 2010, namely the second round of quantitative easing, aka QE2.

With Fed policymakers downgrading their economic forecasts by as much as they did over the past two months?shaving 0.5 percentage points off their estimates for US growth in 2012?they had to take some action to avoid a huge disappointment among investors that risked exacerbating market turmoil. But the majority of Fed officials, aside from the most dovish, appear not yet persuaded that the US recovery is in such bad shape that it is in need of a bold, pre-emptive strike, such as a new round of asset purchase and balance sheet expansion or QE3.

Yet, the Fed also signalled that it was ready to move in that direction if the European sovereign debt crisis worsened further and US economic data, including the next monthly jobs report in early July, shows continued deterioration. Why will the Fed have changed its thinking, compared to the neutral tone it was adopting only a few weeks ago? There are three key reasons for this:

The US economy has slowed markedly since early spring: At the April meeting of the Federal Open Market Committee (FOMC), the central tendency of the committee?s forecast for GDP growth in 2012 was 2.7%, which is a little above the Fed?s 2.5% estimate of long-term trend. This forecast for GDP growth in 2012 is no longer tenable, and has been downgraded in this FOMC meeting. Both manufacturing output and retail sales have ground to a halt in the last 3 months, and the latest ?tracking? estimate for the GDP growth rate in 2012 Q2 has been cut by many analysts to about 1.6-1.8%. The figure for the month of May alone has dropped further, to about 1.5%.

Hence, the growth rate has fallen well below the level which would normally be required to bring unemployment down. Chairman Bernanke has said several times recently that GDP growth will have to be stronger than it was last year in order to reduce unemployment, which is a prerequisite for the Fed doves to leave policy unchanged. Instead, GDP growth has slowed, raising the likelihood that unemployment will actually start to rise, instead of falling towards its ?equilibrium? rate, estimated by the FOMC at 5.6%. The inadequacy of GDP growth is not a short-run phenomenon. GDP growth has only been above trend in one of the last 8 quarters, which must be alarming the doves.

Core inflation is hovering around the Fed?s 2% target: Probably the main reason why the doves fell silent earlier this year was the fact that core price inflation was running at higher levels than had been generally expected. This never seemed likely to prove to be a permanent problem, given the absence of any acceleration in unit labour costs. But the rise in commodity prices was taking time to pass through the rest of the economy, and the Fed had only recently introduced a formal 2% inflation target. The hawks had started to argue that a weakening on the supply side of the economy might be responsible for higher inflation, and even the doves thought it was worth waiting for core inflation to subside before easing again.

Although some of the data have now improved, there is still some concern about core inflation, especially the core CPI, which jumped to 2.7% (3 months rate annualised) in May. Against this, the core PCE seems to be heading downwards, as does the Cleveland Fed?s median measure of underlying inflation. Price expectations built into the bond market are also declining towards the Fed?s 2% target. Overall, the inflation picture might normally induce the Fed to wait another month or two before easing, but the luxury of delay may not be open to them this time.

Financial conditions have been tightening as the economy has slowed: Fed policy has always been highly sensitive to an undesired tightening in monetary conditions, caused by declines in equity prices, rises in credit spreads or appreciation in the dollar. Mr Bernanke in his press conference on June 20 added that more aggressive monetary stimulus would not be ?launched lightly? and would require ?conviction? that it was necessary. He added, ?But if we do come to that conviction, then we?ll take those additional steps.? I believe the deteriorating US economic conditions will lead to that conviction being transformed into action.

There could however be mounting election-year political pressure on the Fed, which may lead to caution. Mitt Romney, the Republican nominee, opposes QE3, as do many Republicans in Congress, and the Fed could face criticism that it is aiding Barack Obama?s re-election effort if it approves new stimulus. Mr Bernanke will try to insulate the institution from politics as much as possible. And on June 20, he said the Fed was ?very serious about taking our decisions based on purely economic grounds, without political considerations?. But the US central bank may ultimately have to bite the bullet and move to QE3.

The author is CEO, Global Money Investor