Many analysts and commentators have argued that investors, having already bought up the stock market because they expect QE3 or some other new monetary policy, have made it less likely for the Fed to ease because stock prices are high.A logical extrapolation from this idea is that the market has to crash before the Fed will open the spigot.
BofA economist Michael Hanson doesn’t like this argument. Here is his take in a note to clients today:
Some in the markets think that the Fed effectively targets equity prices, meaning that to predict Fed policy, one merely needs to track the US stock market. There is a curious circularity to this view, however: the Fed will not launch QE3 so long as stock prices are high, yet the stock market is high because it anticipates QE3…stock and bond prices have decoupled since the summer, as QE3 expectations overwhelmed the weaker macroeconomic data to buoy equities. Now that recent data have improved, yields have risen — but so too have stocks. This “heads I win, tails you lose” aspect of stock prices rising regardless of the macro backdrop makes them a far less useful signal for Fed officials. Moreover, it creates the risk that the equity market could sell off after the 12-13 September FOMC meeting if the Fed disappoints.
Hanson argues that financial conditions are actually not that different from when the Fed launched QE2, even if you include the rising stock market in those measures:
As Chart 1 shows, financial conditions more broadly are not very far from where they were ahead of QE2. Chart 1 plots three measures produced by Fed researchers: a National Financial Conditions Index from the Chicago Fed and two Financial Stress Indexes, one each from the St. Louis and Cleveland Feds. All three are normalized measures in which higher values indicate more stress. The Chicago and St. Louis indexes co-move quite closely (95% correlation coefficient) despite their different construction and units; the correlation of the Cleveland measure with the other two exceeds 70%. Even though rising stock prices are indicative of better financial conditions, in some sense the equity market appears to have it right: broader financial conditions are not so strong to price out QE3.
Here’s the chart of financial conditions Hanson is looking at:
Photo: BofA Merrill Lynch
However, Hanson says he thinks “A little more weakness in the inflation data is probably necessary to make a compelling case for QE3 in September.”