Fed on the Sidelines

The FOMC’s two-day meeting next week is expected to be something of a nonevent.  Caught between a deteriorating growth outlook and higher inflation numbers, it is widely expected that policymakers stand pat.  A consensus view from the Wall Street Journal:

With job gains potentially slowing, housing prices sliding and consumers spending cautiously, officials don’t want to tighten financial conditions. This means they will maintain short-term interest rates near zero and keep the central bank’s $2.6 trillion of securities holdings from shrinking. At the same time, because inflation has picked up, they’re reluctant to embrace new initiatives aimed at boosting growth.

On the growth side, the critical issue is that policymakers believe the second quarter drag is an artifact of temporary factors that will soon fade.  Of course, this was the story last quarter as well, but they seem content to ignore the possibility that a string of temporary shortfalls looks suspiciously permanent.  Indeed, arguably the only thing temporary about this recovery was the one quarter acceleration at the end of the 2010.

Regardless of GDP downgrades, policymakers positioned themselves to turn a blind eye on growth, keeping focused instead on inflation.  And they are seeing what they were looking for. Core-CPI gained 0.3% in May, likely sending shivers down the spines of hawkishly inclined FOMC members.  This was predictable – the gains in headline-inflation were certain to translate into a temporary rise in the core numbers, which would lead the Fed to downplay the growth slowdown.  Moreover, once the obvious threat of deflation was off the table, so too was the motivation for another round of large-scale asset purchases.  In the absence of a downward spiral in 2012 growth forecasts, obvious reemergence of deflation concerns, or a Europe-precipitated crisis on Wall Street, it seems the Fed is content to move to the sidelines.

That said, speculation the Fed is poised for more hangs over financial market participants.  The latest such speculation comes from PIMCOs Bill Gross, who appears to be covering himself after his ill-timed call to go bearish on US Treasuries.  Via Reuters:

The world’s largest bond fund manager said on Twitter late Tuesday: “QE3 likely to take form of ‘extended period’ language or interest rate caps on 2-3-year Treasuries.”

Gross, the co-chief investment officer of PIMCO, the world’s top bond manager, also said on Twitter: “Next week’s Fed statement will likely stress ‘extended period of time’ language or even a period of interest rate caps.”

Now, the extended period language is considered a given so I don’t see much room to stress it further.  Instead, I see some room to back away from it.  Recall the language itself:

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, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.

I think the reference to “subdued inflation trends” could be questioned in light of actual inflation trends.  Which opens up the possibility for a statement that leans a little more hawkish than expectations.  Not my primary scenario, but one worth thinking about.

As to Gross’ second speculation, that QE3 could come as a cap on 2-3 year rates, I very much doubt it will happen, certainly not next week.  While, as Reuters noted, this idea was floated by then Governor Ben Bernanke in 2002, it would mean an open ended commitment to purchasing those securities, and I can’t see anyone on the FOMC with the stomach for that kind of commitment.  This group looks for nothing more than to avoid commitment, trying to unwind policy as soon as possible.  I don’t see them ready to propose.

Moreover, how much traction does the Fed really have in this region of the yield curve?  The two and three year rates stood at 38 and 70 basis points today.  These assets are already barely distinguishable from cash; dragging them down another 20bp will have little impact at the longer end.  Bernanke already stated the tradeoffs for additional action are not attractive.  I would have to agree if the most they are looking for is a handful of basis points; the policy would have little impact and thus only add to the belief that QE2 has done little if anything to lift the economy.

No, I think you have to move further out on the yield curve to get some traction, and I think the Fed knows this.  The numbers to get traction simply make additional easing a bridge too far.  Joe Gagnon,currently at the Peterson Institute, formerly of the Fed, and formerly my supervisor at Treasury, provides some scope via Rortybomb:

While QE2 had good effects, it was too timid. A QE3 needs to be bigger than QE2 — you want to signal a larger amount. A trillion dollars sounds like a big number, but it isn’t like a trillion dollar tax cut. All it is is a swap of two different assets. Buying one kind, selling another.

Bottom Line:  Both monetary and fiscal policy suffer from the same impediment – the numbers needed to be effective, in both the size of the Fed’ balance sheet and the magnitude of the federal deficit, are so big that policymakers view them as potentially destabilizing, while the magnitude to which they might be willing to commit would leave them open to criticism that their policies are failures.  The obvious fallback position is to embrace the devil you know, which in this case is an economy simply limping along.

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