Fed thoughts for 2012: Into the heart of darkness

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This post is a guest contribution by Vincent Reinhart of Morgan Stanley.

Part of the challenge in making a call about Fed policy is that there are many moving parts.  Fed officials can alter the size and composition of the balance sheet and the structure of administered rates (including those charged on discount loans and swap draw-downs and the one paid on excess reserves), as well as the way they communicate decisions.  Our call is that the Fed will pull a few of those levers in 1H12.

Understanding the logic of the timeline and the risks to that outlook requires first appreciating three key features of Fed policy-making:

Three features about the Fed you need to know: The major surprise about the Fed is that so much of what it does follows directly from three obvious, but not well understood, principles:

1. Ambiguity: The mission at the heart of Fed policy-making is ambiguous.  In the Federal Reserve Act, Congress tells the Fed to foster maximum employment and stable prices but is silent on how to weigh deviations from the two objectives or how quickly those deviations should be eliminated.

2. Diversity: Fed officials fundamentally do not agree among themselves on how to weigh relative deviations from the two goals.

3. Democracy: Chairman Bernanke entered office wanting to create a more democratic policy-making committee.  This attitude was shaped by his own experience as a governor and academic work indicating that a group makes better decisions than an individual.

Putting these features together helps to explain a few regularities about policy-making.  First, the Fed tends to go slow because a democratic committee can only get to ‘yes’ with difficulty when its members disagree about its mission.  Second, when it does act, the Fed prefers to lay out programs in fixed amounts with set start and end dates.  A fractious committee is unwilling to make conditional decisions that might depend on the interpretation of the staff or FOMC leaders later on.  Third, the decision itself most likely represents a compromise along many margins, including the size and duration of the action and the wording of the statement.  Fourth, communication is about conveying the sense of the committee.  If the committee cannot come together and its decisions represent compromises at many margins, then its communications may be inconsistent.

These features are being played out as the Fed attempts to conduct monetary policy in an unconventional manner.  When the nominal federal funds rate is stuck at its zero lower bound, the Fed has two ways to ease the stance of monetary policy.  First, it can convey that it intends to keep the policy rate lower and for longer than previously expected.  Second, it can increase the size of its balance sheet or tilt its composition away from relatively riskless to riskier assets.

Talking about talk: The FOMC has been tilling the field of communications, the first tool, for some time.  It issued an unconditional commitment that it would keep the funds rate low for a “considerable” period in 2003 and at zero for an “extended” period since 2009.  Policy-makers hate making such promises, on the fear that they will not be able to respond if economic and market events turn quickly.  So, it must have been with considerable reluctance that the FOMC agreed to be specific about its funds rate promise in August 2011, when it pledged that the rate would be kept at zero through at least mid-2013.

There has been talk, too, of offering a conditional commitment by which the Fed ties the stance of its policy to observable economic indicators.  Effectively, this would entail that the FOMC specifies its policy rule, which butts against the core problem of the dual mandate.  The Fed is assigned an ambiguous task (Principle 1), and its leaders do not agree on its interpretation (Principle 2).  Absent the imposition of order by the chairman (in violation of Principle 3) or a change in the legislated mandate (which is not in the cards in the near future), the FOMC will not be able to pre-commit on future contingencies.

If the FOMC cannot agree on its policy rule, it does have a mechanism to convey its members’ outlook for monetary policy: its four-times-a-year survey of the economic forecasts of FOMC participants.  We know from the just released minutes of the December meeting that the Fed decided to have officials submit their prescriptions for the fed funds rate over the next few years and over the longer run.  This has the advantages of:

1. Showing progress in increasing transparency and being engaged during the lull between balance sheet operations;

2. Underscoring the pledge to keep the funds rate low through at least mid-2013, because the central tendency entries for end-2012 and end-2013 are likely to be zero; and,

3. Making the other parts of the survey more useful by providing enough information to infer the ‘equilibrium’ real funds rate from the participants’ long-run reports on the nominal funds rate and inflation.  Over time, it will also be possible to glean the average FOMC participant’s policy rule.

QE3 to set sail: The big three principles of Fed policy-making also directly shape the prospects for the next round of quantitative easing, QE3.  In particular, Chairman Bernanke has to get a fractious committee (Principle 2) to agree voluntarily (Principle 3) that there is sufficient risk to its ambiguous mandate (Principle 1) to alter its balance sheet to influence markets and the economy in the absence of a consensus about the efficacy of that action (Principle 2 again).  We think he will succeed.

Precedent matters at an incrementalist central bank.  QE1 and QE2 set sail only when measures for both of the Fed’s two objectives pointed downward.  That makes sense because a dual shortfall buys agreement among the membership and offers some protection from political criticism.

The exception to the dual shortfall precondition – the ongoing ‘Operation Twist’ in which the Fed is buying long-term securities and selling short-term ones – is instructive.  When the program started, the Fed held that there was an evident risk to maximum employment, but inflation was around the level consistent with price stability.  To respond to this situation, the Fed is effectively using two instruments to pair with its dual mandate.  Purchases of long-term debt are meant to address resource slack, while sales of short-term securities protect price stability.  However, the Fed can only match such purchases and sales to the extent it has short-term Treasuries in its portfolio to sell.  By the time Operation Twist runs its course, that ammunition will have been spent.

The Morgan Stanley forecast of the US economy hinges on three assessments. First, the vigor of private demand is being sapped by unfinished business left from the incomplete clean-up of the financial crisis.  Second, households and governments (at all levels) will be deleveraging for some time to come.  Third, legislative and regulatory overshooting is already well in train and will put an additional crimp on lending.  As a result, we see the US economy bumping along at around a 2% average growth rate of real GDP in 2012 and 2013.  The unemployment rate is likely to edge lower, with core consumer price inflation moving up a bit further in the very near term and then drifting sideways.

The prospect of a sluggish economy in an election year should sufficiently frighten current office holders to force a compromise stretching beyond the just agreed upon two-month extension of the payroll tax cut and extended unemployment benefits.  Even after such action, however, fiscal policy will likely impart a modest drag on spending growth.

Economic data are volatile, knocked about by special factors from quarter to quarter.  Among the ones in play right now are two tailwinds: the dissipation of both the production disruptions from the Japanese earthquake and the run-up in energy prices earlier this year.  Our forecast is that 4Q real GDP growth is running at a 3.75% annual rate.  However, when those one-off effects are seen in the rear-view mirror and we hit a shallow fiscal pothole, growth should slow to around 2% early in 2012.  We think that this deceleration in real GDP will be enough for the FOMC to declare that there are downside risks to both of its objectives by March, the precondition for QE3.

Specifically, we expect that QE3 will take the form of asset purchases in the neighborhood of US$0.5-0.75 trillion of Treasury and agency-guaranteed, mortgage-backed securities.  Three reasons support this judgment about the mix:

1. Precedent: The Fed has previously purchased MBS backed by the government-sponsored enterprises and can do so again.

2. Concern: More than half of Treasury debt outstanding is in the hands of official accounts, summing across the Fed and foreign official entities.  Purchasing Treasuries exclusively risks disconnecting them from the rest of the fixed income market.

3. Support: Obama Administration officials have come to realize that the ongoing dysfunction in the mortgage market is a key impediment to sustained expansion.  Their problem is that there is no chance of coming to terms with Congress to fix the mess.  The result is that the Administration is moving toward mortgage modification, but not decisively.  Purchasing MBS is a way that the Fed can support that movement and signal the seriousness of the enterprise.

Large-scale asset purchases in an election year are sure to draw considerable political flak.  The Fed should find a measure of protection by emphasizing that inflation would otherwise be poised to fall below its goal.  Indeed, even if core inflation measures continue to drift higher for the next few months, headline inflation will be moving lower.  Also, officials are likely to place more emphasis on contained long-term inflation expectations and may even start to publicly downplay the significance of rising shelter costs – one of the main drivers of the acceleration in core inflation over the past year or so.

The Fed might also find safety in numbers.  Coordinated QE by the major central banks in the spring would align well with their various self-interests.  In addition, consider two relevant points:

1. New-found aggressiveness: Mervyn King, governor of the Bank of England, has chaired the global economic monitoring committee of the ‘bank for central bankers’ – the Bank for International Settlements – since November 1. News reports indicate that he was instrumental in pushing for the coordinated cut in the rate on swap lines in his first month on the job. This enthusiasm is unlikely to ebb.

2. Long-held history: As a scholar of the Depression, Chairman Bernanke understands that coordinated currency devaluations against gold in the early 1930s would have been much more effective than the unsynchronized actions (in timing and size) that were actually taken.  He wants to do better.

The Fed could buy even more inflation insurance by sterilizing the effects on reserves of those asset purchases.  As noted, the Fed does not have scope for continued sales of short-term securities, given its dwindling holdings.  In principle, the Fed’s open market desk could arrange temporary reverse repurchase agreements to drain reserves.  However, the FOMC would probably be reluctant to commit to such a plan unless it was completely confident that large-scale draining operations could be pulled off without a hitch, which is tough for a divided committee.

Where might we go wrong? The roadmap of Fed action seems self-evident, but there are plenty of opportunities for bumps along the way.  Exhibit 3 in our full report traces the likely consequences of key potential surprises in the economic outlook in terms of Fed action.  The bottom line is that it is easy to imagine events that raise, rather than lower, the odds on QE3.

The shaded row is our baseline of muddling through 2012, consistent with the Fed announcing large-scale asset purchases by May.

Congress and the Administration have just compromised on extending unemployment benefits and payroll tax cuts, averting a noticeable fiscal drag on spending in the first part of the year.  However, the extension only lasts for two months, so there will be additional opportunities for name-calling and general confusion in coming months.  Should political gamesmanship in Washington produce self-inflicted wounds for the economy early in 2012, the Fed would launch QE3 a little earlier in the year, in our view.

A comparable failure of the European political class in managing the banking and sovereign debt crisis would compound the risk to the global economy.  Increased strains in markets and a deep contraction in Europe would produce difficult cross-currents for the Fed to navigate.  Large draw-downs of the swap lines with the ECB would swell the Fed balance sheet.  If there were contagion to US markets, a few of the market-supporting Fed facilities used in 2008-09 would likely be taken down off the shelf.  QE3 would eventually come, but it would be a balance sheet-maintenance program, similar to QE1, once the dust had settled.

The global economy would go into a wrenching contraction if the problems in the advanced economies swamped the Chinese authorities’ ability to pull hard enough on their levers of policy.  The associated decline in commodity prices would engulf the other Pacific Rim economies.  From the narrow perspective of the Fed, this would signal all central bank hands on deck to launch QE3, or to increase its size if it were already afloat.

US economic data have run stronger than expected over the past month.  We think this owes to a swing of special factors and an unsustainable dip in the saving rate.  But we have to put some weight on the possibility that this is an early indication of a breakout from the low-growth rut.  Even if this proves to be the case, we doubt that growth would pick up sufficiently to put pressure on the labor market in the first half of next year.  Thus, rather than deterring the Fed’s balance sheet expansion, we think Fed officials would reason that those ‘green shoots’ needed more nurturing this time around.

Any associated equity market rally would be extended if the longer-run prospects for US fiscal policy were clarified, however unlikely that seems right now.  But here, too, Fed officials would presumably want to be supportive of that effort, especially as it would probably signal near-term fiscal consolidation.

Forceful resolution of the ongoing problems in Europe would be the most bullish outcome for the global economy.  It is also the outcome – in the unlikely event it materialized early in 2012 – that would most put QE3 at risk, in our view.  A lessening of uncertainty and encouragement of risk-taking, along with some dollar depreciation in light of the stronger foundation for the euro, would ease financial conditions here, obviating the need for the Fed to act.

This high-level tour of the map of risks suggests that it is easier to foresee events that grease the skids for QE3 than those that pose a significant obstacle.  The timing, size and composition of QE3 are policy decisions determined by the hand that the Fed is dealt.  Because it is likely to be dealt a bad hand in 2012, that the Fed will do QE3 is more certain than precisely how or when it will do so.

Source: Vincent Reinhart, Morgan Stanley, January 5, 2011.

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