Roubini: What’s ahead for the Fed?
The report below comes courtesy of Nouriel Roubini’s team of analysts at RGE.
“An anemic and subpar U.S. recovery amid balance-sheet repair, weak demand, slack in the economy and disinflationary pressures has always been our baseline scenario. By the summer of 2010, the disinflationary bias in expectations had become more evident, and the economy – lacking a self-sustained recovery – had started heading toward a dangerous stall speed. We vocally expressed our concerns around deflation/stagnation/double-dip scenarios and called for more policy action, while recognizing that the effects on the real economy would be limited.
“Fed Chairman Ben Bernanke’s Jackson Hole speech signaled that the Fed would do whatever is necessary to ensure the recovery, but it was not until the September Federal Open Market Committee (FOMC) meeting that the gradual change from a tightening to an easing stance was officially formalized. We (and the markets) now believe the Fed next month will announce a program for further quantitative easing – QE2. In ‘Quantum(s) of Solace: A QE2 Scenario Analysis and Assessment of the Limits of Fed Policy’, available exclusively to subscribers, we lay out a scenario analysis that explores the shape this program could take and the implications for growth and the different asset classes. We also ponder the possibility that the Fed will have to extend the program and announce QE3 (and eventually even QE4).
“Under our baseline scenario, to which we assign a 60% probability, the November FOMC meeting statement will announce a large-scale asset-purchase program (LSAP) of roughly US$600 billion. Recent speeches by several of its regional presidents indicate the Fed will engage exclusively in the purchase of long-term Treasurys in QE2. We expect it to announce that these purchases will occur at a pace of around US$100 billion–150 billion every month for four to six months, into 2011.
“We also expect the Fed to change its language regarding the maintenance of zero policy rates to ‘a very long period’ or ‘until economic indicators are in line with the Fed’s mandate’, from the current ‘for an extended period’. Toward the end of the stipulated purchase period, the Fed will consider whether the size of its balance sheet is consistent with its mandate and will decide upon the necessity of further action, then more QE may be announced if growth and inflation are still expected to be well below potential and target.
“While markets appear to be pricing in roughly US$500 billion of additional purchases, the Fed might surprise the markets with a slightly higher purchase program. Our second scenario for QE2 is a ‘shock and awe’ LSAP program of some US$1 trillion–1.5 trillion, to which we assign a probability of 20%.
“Under our third scenario, to which we also assign a 20% probability, the Fed would not announce a fixed amount for the entire QE package but instead would stipulate only the amount of the first purchases – some US$100 billion–150 billion. The Fed would indicate that the purchases would continue at that pace while keeping the length of the purchase horizon state-contingent – i.e. until economic indicators are deemed to be in line with the Fed’s mandate. Alternatively, the volume of purchases could be announced at each FOMC meeting, and both the volume and purchase horizon of the entire stimulus effort could be state-contingent, an option that would grant the Fed even greater flexibility.
“There are several reasons to expect the effects of QE2 on growth to be contained. This projection does not change much under each scenario, although at the margin the chances of the U.S. falling into a double dip are reduced. We continue to stress that household balance-sheet repair will continue to dictate the pace of the recovery and that liquidity can only have a limited impact and cannot be a solution to solvency issues.
“Looking ahead to 2011, our outlook for growth factors in that the fiscal stimulus and the effects of the inventory-restocking cycle in 2010 will not only fade by next year but will become a drag on growth. House prices are projected to correct downward in 2011, and consumer spending will remain anemic as consumers continue the process of deleveraging and repairing their balance sheets and the slack in the labor market depresses growth in wages. These factors point to anemic growth and easing inflation in 2011.”
Also, with the GOP slated to take over the House, Roubini told CNBC the Congressional gridlock will get even worse, leading to a “fiscal train wreck”.
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