Yesterday, we got to see the Fed’s minutes from their January 24th-25th meeting. On everybody’s mind was the possibility of more quantitative easing (QE). QE has become a fantasy drug that investors have become addicted to. We thrive in its effect as asset prices are inflated higher, and we suffer withdrawals when the trip ends. Each Fed meeting after a conclusive run of QE, investors beg for the next hand out, addicted to the high it brings. The consensus seems to be less than 50-50 for another round. Some are even calling it a Wall Street Fantasy. The reality, however, is that this is the only real tool available to the Fed should conditions worsen or unemployment remain stubbornly high. Forecasting low interest rates out to 2014, that’s a lot of time in which the balance sheet will be the main source of policy change.
I think the debate on QE3 really kicked into high gear when we got the jobs data on Friday, February 3rd. Payroll employment by the Bureau of Labor Statistics (BLS) showed employment rising 243,000 for January. The unemployment rate fell to 8.3% as the participation rate fell to 63.7 from 64, where it has hovered there for more than 7 months. There has been a lot of debate about those numbers based on the BLS’s methods of tracking and modeling the data. Regardless of their method, we can extract a trend, and that trend has been steadily rising since the 2009 bottom in the economy - as it did from 2001 to 2005.
With the strong economic data, doubts crept into the mind of market participants. If the economy is improving, why should the Fed offer more QE? QE has been used as a method of loosening economic policy. If the economy improves, it doesn’t make sense to loosen policy. We’ve started seeing all of the FOMC members give their two cents in the debate lately. Wednesday last week, San Francisco Fed President, John Williams, shared his thoughts.
“Lower interest rates alone can’t fix all the economy’s problems. But they do help. Conditions are far better today than they would be if the Fed hadn’t administered such strong medicine. Looking ahead, we may still need to provide more policy accommodation if the economy loses momentum or inflation remains well below 2%. Should that occur, restarting our program purchasing mortgage-backed securities would likely be the best way to provide a boost to the economy.” Bishop Ranch Forum speech, February 8, 2012
So essentially, Williams has stated QE3 will be a backstop. The debate is red hot right now between the hawks and the doves. Earlier this week, we had yet more conflicting headlines from both, Williams and Charles Plosser, the Philadelphia Fed President. Monday, Williams reemphasized his view from last week that “it is vital that we keep the monetary policy throttle wide open” to continue to improve employment and bring inflation back up to the Fed’s 2% target. Plosser fired right back on Tuesday saying “the accelerationist approach to monetary policy” was not necessary with signs of the economy improving. He believes the Fed should shift to a neutral policy.
In addition to Plosser, we got some more headlines from the hawkish side of the debate on Wednesday before the FOMC minutes were released. Dallas Federal Reserve Bank President, Richard Fisher, stated “Wall Street keeps dangling QE3 out there…I think it’s a fantasy of Wall Street – it’s not going to happen, it’s not necessary.”
The FOMC minutes were finally released yesterday. You can read it here. Analysts were madly sifting through the FOMC tea leaves to try and make sense of the debate between the Presidents over the past two weeks. That debate was made no clearer yesterday. Essentially, half of the minutes state that the economy has moderately improved and the employment numbers remain consistent with modest employment growth. The other half keeps the door wide open for QE3 with low inflation rates and an unemployment rate that remains elevated. Here are some of the bullet points the FOMC minutes focused on in the release.
Factors Moving Against More QE
- Labor market improvement
- Firm hiring plans improved
- Industrial production up in Nov and Dec
- Manufacturing activity suggesting moderate growth in production
- Real personal consumption expenditures continue to rise modestly
- Consumer sentiment improving but at low levels still
- Starts and permits for new homes on the rise
- Sales of existing homes firming
- Wage gains modest
Factors For More QE
- Long-duration unemployment high
- Workers employed part time for economic reasons too high
- Household real disposable income edged down
- While consumer sentiment is improving, still at low level
- Housing prices held down by large overhang of foreclosed and distressed properties
- Business expenditures on equipment and software decelerated in fourth quarter
- Commercial construction held back by high vacancy rates and tight credit
- Significant decline in defense spending from the federal government
- Exports of industrial supplies and materials were weak since Nov
- Consumer prices unchanged in Nov and Dec
- Long-term inflation expectations remained stable per Thomson Reuters and the Univ. of Michigan Surveys
- Substantial deceleration in foreign economic activity over the fourth quarter
- Fiscal tightening in the U.S.
- Household deleveraging
- Volatility in financial markets until fiscal and banking issues in the euro area are more fully addressed
Fantasy Or Reality
While conditions have improved, there is no doubt the Fed has essentially left the door open for QE – and why wouldn’t they? The Federal Funds rate is at 0 to 25 basis points. That leaves communication and the balance sheet as the only two policy tools they expect to use until late 2014 when they forecast rates will start to rise.
“The Committee also stated that it is prepared to adjust the size and composition of its securities holdings as appropriate to promote a stronger economic recovery in a context of price stability. A few members observed that, in their judgment, current and prospective economic conditions—including elevated unemployment and inflation at or below the Committee’s objective—could warrant the initiation of additional securities purchases before long. Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run. In contrast, one member judged that maintaining the current degree of policy accommodation beyond the near term would likely be inappropriate; that member anticipated that a preemptive tightening of monetary policy would be necessary before the end of 2014 to keep inflation close to 2 percent.”
Material stocks have been underperforming since the February 3rd jobs data when investor began to doubt QE3; however, today, they were the best sector and the XME and GDX industry ETFs were among the top industry groups in the S&P 500. The likely response was due to some technical factors (near support) but also on economic data (Philly Fed, housing starts, jobless claims) and headlines out of Europe on a likely Greece bailout. So while materials may have lost some of their QE3 premium, let investors not forget that the Bank of England, European Central bank, and the Bank of Japan all have their spigots wide open. In my opinion, we haven’t seen enough movement in gold miners and material stocks to reflect this wave of global QE and accommodative monetary policy.
Concerning QE3, I don’t think there is an imminent use for it now as the leading economic indicators have been improving for 5 straight months. We have a bazooka in Europe called the Long-term Refinancing Operations that has stemmed the tide of rising sovereign yields. GDP there shows France and Germany improving while the peripheral nations continue to contract. The issue is whether you’re a country that’s issuing austerity measures or not. If the U.S. begins to turn towards austerity measures, which looks likely looking at Obama’s deficit proposal and budget and in Congress with the growing appeal of the Tea Party, well then the need for loose monetary policy might be great. That might be one of the main factors the FOMC see rates going out to late 2014. With interest rates near 0, the only ammunition besides the jawbone is quantitative easing. That makes the possibility of QE a reality as the key policy tool for the Federal Reserve Bank and not a fantasy. That is why the FOMC minutes leave the book wide open on the subject.
