February 17th, 2012
In undertaking the Maturity Extension Program (Operation Twist) last September, the FOMC sought to “support a stronger economic recovery and help ensure that inflation over time is at levels consistent with the Federal Reserve’s mandate to foster maximum employment and price stability.” As the $400 bln program passed the half way point this week, dealers are evaluating the progress toward satisfying the dual mandate, the need to extend the MEP or to follow it up with another round of large-scale asset purchases (QE3). Dealers’ opinions on the likelihood of QE3 seem to hinge not on where employment and inflation are today but where they are when Operation Twist ends in June.
About the only readily available economic indicator that doesn’t already show at least some progress toward satisfying the Fed’s dual mandate is the core CPI, which in January moved away from price stability by rising to 2.3% y/y. Seen another way, however, the real Fed funds rate with respect to the annual change in core CPI is now the lowest (i.e., the most stimulative) since July 1980. Real 10-year note yields are also profoundly stimulative, as is Friday’s passage by Congress of the payroll tax cut extension. Nevertheless, progress over the last 4.5 months can be measured in inches, not the yards the Fed wants to see before agreeing to withhold additional stimulus.
Dubious of the need for additional stimulus beyond June, Deutsche Bank Global Markets Research suggested the Fed should start by raising its core inflation forecast. “We do not see how core inflation will remain within the Fed’s specified 1.5% to 1.8% range in 2012. We believe this is much too low, as a projected rise in the core CPI to 2.7% by yearend should pull the core PCE up to at least 2.2%. This is another reason why we do not expect the Fed to embark on QE3 or to extend ‘operation twist’ beyond June, its scheduled end date.” Meanwhile, in a Fixed Income Special Report published Friday, DB strategists wrote, “We think ‘front running’ the Fed is a bit premature at this point, as the twist program still has about 4.5 months to go. Remember that the market was wrong in ‘front running’ the Fed QE2 in the first quarter of 2011 by pushing yields higher. The exact opposite happened in post-QE2 trading, when the economy weakened and debt crisis in Europe escalated. On near term technicals, we think the curve could flatten into the month-end Treasury note supply, which comes a week earlier due to a shorter calendar month.”
Seemingly in agreement, Lloyds Bank Wholesale Banking & Markets said Friday, “As both headline and core measures of inflation currently exceed the Fed’s implicit inflation target, the timing is not propitious to launch a third round of QE as some FOMC members suggest. If inflation falls further into H2 as ‘Operation Twist’ expires, this may provide more room for maneuver. However, by that stage we are hopeful of seeing more convincing signs of recovery, which should stay the Fed’s hands particularly in the face of the approaching Presidential Election.” In part due to the divergence of the spread between US 10-year note yields and the Citigroup Economic Surprise Index, LBWBM favors a bear steepening in US rates but sees 2.35% as a near-term backstop for 10-year yields.
Recapping Friday’s CPI report, Bank of America Merrill Lynch indicated that the Fed will simply wait for more data. “Despite the increase to a 2.3% annual core inflation rate, most Fed officials still expect inflation is set to soften over the course of the year. While the Fed won’t react to one data report, several months of strong reports would introduce more caution into their assessment of the need to ease further. In light of the data, we do not expect the Fed to launch QE3 during the first half of 2012, especially with Operation Twist still in place through end June. Since Operation Twist accomplishes much of the same things as QE, we see QE3 more likely to start in the second half of the year – after Operation Twist [has ended] and the economy starts to slow.” BAML economists “also recommend fading claims that QE has to be early to avoid the election” but says, “Below-trend growth or a rise in unemployment from here might well be enough to launch QE3, in our view. Conversely, it would take a significant improvement in growth and projected inflation at or above target to take QE3 completely off the table.”
For Barclays Capital, the FOMC minutes released February 15 indicate QE3 is by no means “off the table” but the dealer contends that further stimulus may not be compulsory. BarCap economists wrote Friday, “QE3 would be implemented if disinflationary risks were seen to have risen significantly, but that seems unlikely absent a softening in growth. Thus, we think that if economic growth weakens over the next few months, then QE3 will come under serious consideration, but if the economy grows moderately, as we expect, QE3 will not be seen as needed.” Nevertheless, says Barclays, the annual rate of inflation “presents no obstacle to the FOMC in its ongoing efforts to stimulate the economy further.”
Despite some visible signs of the maturity extension program’s success, Exane BNP Paribas Global Economics Research and Investment Strategy says QE3 is still likely in H2. “We believe that the better macro data of late is a vindication of the Fed’s aggressive approach. As such, the need for QE3 remains as the economy is still struggling to reach trend growth. With large amounts of spare capacity still in the economy, disinflationary forces will likely be in play for much of this year. Indeed, we believe that the core PCE inflation rate – the Fed’s preferred measure – is likely to trend lower from 1.8% currently to 1.6% by year-end.” In terms of the size of QE3, Exane BNP expects “around $500 bln of asset purchases, including a mix of treasuries and mortgage-backed securities.”
The U.S. economic indicator calendar in the February 20-24 week leaves a great deal to the imagination as far as handicapping QE3 goes. On Friday, February 24, however, two non-voting hawks (Plosser and Bullard) and two voting doves (Williams and Dudley) will dig in their heels at the 2012 U.S. Monetary Policy Forum hosted by the University of Chicago Booth School of Business. FRB New York’s Dudley (voter, dove), for one, has often stated that he believes the Fed can do more to fulfill the dual mandate. And as those in favor of QE3 represent the core of this year FOMC, there are still greater than even odds that additional asset purchases are coming.