View: Fed doves ready to act | Gavyn Davies

Fed doves ready to act | Gavyn Davies

As the eurozone crisis enters a critical phase, market attention is once more focused on the central banks to contain the crisis. They have promised in advance to provide unlimited liquidity to solvent financial institutions if necessary in coming weeks, which is now their standard response to financial shocks. However, the slowdown in global activity caused by the euro crisis may mean that they are thinking of acting more aggressively than that. A further large bout of unconventional easing is now on the agenda.

As usual, the Federal Reserve will be the critical player in leading a co-ordinated easing in global monetary policy. Until recently, the Fed was not generally expected to ease policy at all after the FOMC meeting on Tuesday/Wednesday of next week, but economic conditions inside the US, not all of which are directly related to the eurozone crisis, have now changed markedly.

It would be surprising if the FOMC does not react to these developments by easing policy next week, and the likelihood of an aggressive move (a QE3) may be greater than the market thinks.

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:

1. The US economy has slowed down markedly since the early spring.

At the April meeting of the FOMC, the central tendency of the committee’s forecast for GDP growth in 2012 was 2.7 per cent, which is a little above the Fed’s 2.5 per cent estimate of long term trend. This forecast for GDP growth in 2012 is no longer tenable, and it is likely to be downgraded to around 2.0-2.2 per cent this week.

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 per cent. The figure for the month of May alone has dropped further, to about 1.5 per cent.

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 per cent.

The inadequacy of GDP growth is not a short run phenomenon. As the graph above shows, GDP growth has only been above trend in one of the last 8 quarters, which must be alarming the doves.

2. Core inflation is now hovering around the Fed’s 2 per cent 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 per cent 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 per cent (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 per cent 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. This is because:

3. 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. This is exactly what has happened since the April meeting of the FOMC. Some of this is certainly due to financial strains in the eurozone, though these have in fact been fairly well contained ever since the LTRO’s in December and February. More important has been the drop in the euro, and the weakening in global activity which has brought equity prices lower. As a result, the Morgan Stanley Financial Conditions Indicator has tightened almost as much as it did last summer, when it prompted the Fed to act.

Conclusion

Goldman Sachs and Morgan Stanley both think that that this tightening in monetary conditions will induce the Fed to act more aggressively than is generally expected this week. According to a recent survey undertaken by the Wall Street Journal, 63 per cent of market economists do not expect the Fed to announce a QE3-style increase in its balance sheet, and only 43 per cent expect a lessor action, such as a renewal of Operation Twist (which is scheduled to end this month), or more dovish guidance on the future path for interest rates. But Goldman Sachs says its quantitative model assigns a probability of 75 per cent to easing this week.

Vincent Reinhart of Morgan Stanley, who in a previous role attended many meetings of the FOMC, judges that there is an 80 per cent chance of easing, and if it occurs, he says there is a 70-30 chance that it will come in the aggressive form of QE3, rather than another Operation Twist. He says that, in a crisis, the controlling majority of doves supporting the Chairman will re-assert their authority over the relatively hawkish regional governors who often speak loudly between FOMC meetings. I think he may well be right.

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