In my last post I argued the Fed will tend to look through an transitory inflation increase – especially any that can be traced back to commodity prices – as the economy marches toward potential output, and thus not rush into policy tightening. The string of downgrades to Q1 growth, however, is a reminder there is no guarantee that march will continue in a timely fashion. To what extent will the Fed tolerate growth that falls short of their forecasts? What is the tipping point for QE3?
Start with the most recent Fed economic projections from the January FOMC meeting. Although Q1 is looking weaker than anticipated, I doubt the projections will change much, as most policymakers will try to look through any one number to the underlying trend. The Fed is looking for Q4/Q4 growth in the 3.4-3.9 percent range this year. The longer run projection is 2.5-2.8 percent, a common estimate of potential growth, so the Fed projects closing the output gap by roughly a percentage point this year.
The downgrades to Q1 forecasts arguably place that forecast in jeopardy. Again, I don’t think the Fed will see it that way. I think they will see it as noise, especially if they are not picking up a lot of anecdotal information otherwise – I anticipate today’s Beige Book release to signal the recovery continues, with concern about energy prices eating into consumer spending. Moreover, notice this post from Calculate Risk with two interesting items. The first is from Goldman Sachs analysts, who argue that high frequency data suggest the pace of activity accelerated throughout the quarter, and thus the second quarter will be stronger. The second is a link to a WSJ article describing a shortage of rail cars. Both stories suggest a weak Q1 showing is more of a statistical aberration than anything else. Fed officials will be attracted to this line of reasoning.
I have argued that the pace of job creation suggests growth near or a little above trend, and thus myself have tended to discount a weak Q1 GDP report. Interestingly, the IMF delivered an updated assessment of the world economy, forecasting US growth of 2.8 percent (annual average), just about potential output. In contrast to the Fed, which expects growth to accelerate in 2012 and 2013, the IMF expects growth to be relatively unchanged for the next three years, which suggests little if any closure of the output gap and much higher unemployment than the Fed expects.
The Fed and IMF views are dramatically different. At this point I would add the words of wisdom once offered by a close friend: Always bet against the IMF. I think this stemmed from frequent IMF announcements that the “crisis is contained,” which rarely turned out to be accurate, but always an opportunity to short some emerging market currency. But, that aside, suppose the reality is looking more like the IMF view by the middle of this year, is there room for QE3? This quote (via the WSJ) from New York Federal Reserve President William Dudley suggests not, or at least not immediately:
I’d be very surprised if we didn’t complete QE2 [referring to the Fed’s second round of quantitative easing]. After that, though, the hurdle for QE3 is higher… One reason we embarked on QE2 was we really were worried about the risk of deflation in the U.S… Now the risks of deflation are greatly diminished. So one of the motivations behind QE2 is no longer in place.
The deflation threat was key reason the Fed stepped up the asset purchase program. Now no one is talking about deflation. And unless commodity prices just collapse, nor will they by midyear. Why? I suspect we will still be experiencing some of the pass through from the recent commodity price hikes for the next few months, which will be enough to keep Fed hawks riled up. Even if the economy is limping along near potential, jog growth should be steady if not exciting. I suspect that a touch of inflation coupled with growth, albeit lackluster, would make it difficult to clear the bar for QE3.
One could imagine that situation changing in early to mid-2012 as the transitory effects on inflation fade. And, of course, assuming the IMF is right and the Fed is wrong. If the Fed’s forecast is accurate, by early next year they will be looking to tighten.
Finally, a final interesting quote from Dudley:
It’s important to recognize that even with these commodity price pressures, other measures of inflation are very quiescent… There is no sign of any second round effect. Wages are rising very slowly and unit labor costs are running very very flat.
Watch wages it you are worried the Fed is getting behind the inflation curve, and notice Dudley points specifically to unit labor costs. The core of the Fed will resist panic unless unit labor costs start spiraling upward. Then they will panic.
Bottom line: Weak Q1 GDP is not likely to upset the Fed’s basic outlook. At best it is another nail in the coffin for any argument to pull the plug early on QE2. But even if growth comes in below the Fed’s forecast this year, the hurdle for QE3 is high. I think monetary policymakers would need to see clear evidence that the risks are turning back toward deflation. And unless growth is far weaker than expected, such evidence is unlikely to return until late this year or early next year.