Photo: AP Images
The Fed is set to meet next week, and thanks to Friday’s disappointing jobs report, economists have raised their odds of seeing QEIII adopted.That would mean that in an effort to boost the economy, the Fed would buy more purchases… perhaps Mortgage Backed Securities with the purpose of bringing down interest rates for homebuyers.
In a note put out last night, Goldman’s Sven Jari Stehn presents: The Case for a Double Punch in September.
Stehn’s paper actually keys off of the Michael Woodford Jackson Hole paper that everyone has been talking about, wherein the famed monetary economist calls for the Fed to adopt Nominal GDP targeting, making the argument that forward guidance is much more powerful than asset purchases, which Woodford mostly deems to be ineffective.
Stehn is sympathetic to Woodford, especially on the target part, but thinks Woodford “sells QE short.”
Asset purchases do reduce interest rates, argues Stehn.
Their explanation is pretty technical (“First, we attempt to model explicitly the FOMC’s forward guidance using the slope of the Eurodollar curve (three years ahead minus one year ahead…”), but the gist is that their models find a meaningful impact on yields from both the guidance and the asset purchases.
Based on their work, a lot more juice can be squeezed by an asset purchases/guidance combo.
Photo: Goldman Sachs
As such, Goldman calls for what it calls a “double punch.”
What do these considerations imply for the FOMC’s next steps? One important factor to consider is that stylised models of the economy—such as the toy model discussed above and the models Michael Woodford has developed—ignore the potential risks associated with adopting an aggressive state-contingent commitment such as the Evans proposal or a nominal GDP level target. For example, these models do not allow for the possibility that inflation expectations might get dislodged after a period of above-target inflation. Given the potentially large gains in economic performance, one can certainly argue that such risks would be worth taking. But they do explain why a cautious institution such as the Federal Reserve remains reluctant to embrace these aggressive forms of forward guidance.
In practice, we therefore believe that less aggressive forms of strengthening the forward guidance—such as a simple shift in the date for the first rate hike—are more likely at this point. Even these could be quite effective if the yield curve was still very steep, because Fed officials could then push down the forward rate structure substantially. With the curve as flat as it is, however, a simple shift in the date is probably insufficient on its own to deliver a large amount of monetary accommodation at this point.
This suggests that the FOMC will need to combine a shift in the date with renewed asset purchases. In practice, we expect the committee to extend the rate guidance from late 2014 to mid-2015 or later—possibly coupled with a modest reformulation of the forward guidance sentence to emphasise the desire to promote economic recovery—and to announce an open-ended asset purchase program of around $50 billion per month, with an end date that is made dependent on progress in the economic recovery. Taken together, these measures would probably amount to a meaningful monetary easing step, although they still fall short of the boost that could be delivered by the more aggressive forms of guidance advocated by Woodford and examined in some of our own past research.
Photo: Goldman Sachs
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