And so we return to that point when the most engaging, yet useless, topic of discussion is what Bernanke will say or the Fed will do, in this case this coming Friday at the 2011 edition of the Jackson Hole Fed meeting, and specifically Ben’s keynote speech.
By now we have seen endless iterations of what pundits expect will happen: from nothing to another round of QE.
Today, we present SocGen’s take which is that while an outright third round of monetization is unlikely for now, the Fed may well proceed with a lite version of QE in the form of “sterilized” operations, or curve targeting, aka Operation Twist, as was noted here some time ago. One thing we certainly agree with SocGen on: “If markets remain under pressure, Bernanke could be forced to commit to something next week.” The market obviously knows this, in which case if the market case is for QE3 or bust (and remember: Wall Street is still stuck in beta levered world where the only P&L comes courtesy of the Fed this will be most welcome) today’s latest vapor rally will be promptly nullified by Wall Street which has only 4 days left to send a very loud message to the Chairsatan.
From SocGen: Great Expectations For Jackson Hole
Bernanke’s Jackson Hole speech will be the highlight of the week. Expectations are high, but those looking for an outright commitment to QE3 are likely to be disappointed. QE3 may well happen eventually, but the Fed will likely use up more conventional and less controversial tools first. The most likely next step in our view is a duration extension of the Fed’s securities portfolio. Bernanke could refer to it as “sterilized QE,” giving the markets what they want to hear. Other options include broadening policy guidance to include the balance sheet. For example, the Fed could promise not to reduce its securities portfolio until 2013 or, better yet, promise to keep it “at least” at the current size until 2013. The latter would open the door to QE3 more formally, yet without committing to it outright. The Fed could also cut interest on reserves or shift to outright inflation targeting. Price level targeting would be the nuclear option, but it is probably too early for that.
Sentiment measures in the US have continued to slide last week. Early regional manufacturing surveys for the month of August suggest that the national ISM could print in the mid 40s. A 42 level has historically been consistent with flat GDP growth and therefore is a threshold for recessions. In this context, the risks are certainly growing. To be sure, hard activity data has held up well so far: retail sales, production and employment all increased in July, suggesting that Q3 will see positive, albeit slow GDP growth. Our real time recession probability model, based on the four coincident indicators used by the NBER in dating business cycles, suggests only a 2% chance that the economy was in a recession as of July (see the accompanying chart). However, if financial conditions and sentiment continue to deteriorate – and our view is that much of that depends on European policymakers – we could start seeing cracks in hard data in the fourth quarter. At the moment, we would peg recession risks around 40%.
If there is a recession in the next 12 months, it is not all that clear what it will look like. Given that the US economy is already operating well below capacity (nearly 7% by CBO estimates), it is hard to imagine another deep contraction. Instead, we would probably see flat or even slightly positive GDP growth, but below the pace needed to sustain employment gains. For example, 1.0% GDP growth, if sustained, would lead to a roughly 1% contraction in employment which is equivalent to 10k jobs lost per month. This would push the unemployment rate higher, toward the 9.5%-10% range over the course of one year. Inflation would likely ease, opening the door for further monetary and perhaps even fiscal accommodation.
Next week’s Jackson Hole meeting is awaited with much anticipation. Bernanke is due to speak on Friday and markets are looking for a commitment to further monetary support. The focus of the speech is likely to be on additional easing tools which were discussed extensively during the August 9 FOMC meeting. The tools include further language guidance (for example no balance sheet contraction until mid-2013), cutting interest on reserves, changing the composition of the Fed’s securities portfolio, or establishing an outright inflation target. A more controversial option would be price level targeting, but it is a long shot to expect Bernanke to endorse such a radical policy shift at this stage. Finally, there is of course the option of QE3.
We still think that it is too early for a QE3 commitment. For now, both inflation and inflation expectations remain quite high. The CPI report for July certainly did not make things easier for the Fed. It showed some evidence of pass-through and rising rents are also adding to upward pressure on core inflation. These could reverse eventually if the economy continues to grow at or below stall speed, but the Fed will have to wait. As for inflation expectations, they are finally moving in the right direction. The 5y5y forward breakeven dropped over 30bps last week to 2.52%. If this trend continues, an important hurdle to further quantitative easing could be lifted before year-end.
The political backdrop is another important consideration which complicates matters for the Fed. Conservatives remain firmly opposed to ‘printing money’ and have been very vocal about it. Though the Fed should in theory be independent from the political process, Bernanke surely does not want to put the central bank in the cross hairs of a presidential campaign. The bottom line is that the Fed will ultimately do what is right for the economy, but it will need to build a strong case first.
If markets remain under pressure, Bernanke could be forced to commit to something next week. If so, the most likely next step in our view will be duration extension of the Fed’s portfolio. Bernanke could even call it ‚sterilized QE,? giving the markets what they want to hear. The impact would be similar to outright QE with the curve likely flattening further and pushing yield-hungry investors into riskier assets. However, the impact on the dollar would be more limited as there is no outright increase in the money supply.