QE II Set To Sail, But How Soon?
by Dr. Scott Brown, Chief Economist, Raymond James
October 4 – October 8, 2010
In its September 21 policy statement, the Federal Open Market Committee indicated that it was “prepared to provide additional accommodation if needed to support the economic recovery and to return inflation, over time, to levels consistent with its mandate.” The key part of that phrase is “if needed.” Growth and inflation are both too low for the Fed’s comfort, but are they low enough to force the Fed’s hand? In their public comments, senior Fed officials appear split, with some wanting to do more and others less. The most important development last week was a report that Fed policymakers are considering smaller-scale quantitative easing, which should be more palatable to the more cautious members of the FOMC.
“Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.” – FOMC statement, September 21
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Most central banks have an inflation target. The Fed does not. The Fed has a dual mandate: maximum sustainable employment and price stability. In practice, the Fed believes that by keeping inflation low, economic growth will be better over the long run. However, the Fed does not view “price stability” as 0% inflation (as measured by the Consumer Price Index or PCE deflator). Rather, as former Fed Chairman Greenspan put it, price stability is “a situation in which households and businesses in making their saving and investment decisions can safely ignore the possibility of sustained, generalized price increase or decreases." Comments from various Fed officials over the years have suggested an implicit comfort range of 1% to 2% in the PCE Price Index. The PCE Price Index ex-food & energy rose 1.4% over the 12 months ending in August. However, most other measures of core inflation have been trending below 1%.
Models of inflation are driven largely by a measure of excess capacity (an output gap or the unemployment rate) and inflation expectations (which act to anchor the underlying trend in inflation). As long as there is sufficient excess capacity, there will be downward pressure on inflation and over time, if actual inflation continues to trend below inflation expectations, inflation expectations should decline. Note that higher commodity prices generally do not have much of an impact at the consumer level – except for oil, which is more pervasive.
What will it take to get the Fed to pull the trigger? Most officials appear to be leaning in the direction of further quantitative easing, but it’s unclear when it will happen. The recent economic data have been consistent with a subpar rate of growth in the near term – positive, but well below the pace needed to absorb new people into the workforce and far below the rate we’d like to see at this point in the recovery. There’s nothing in the recent data to suggest that we’re in a double dip. However, growth is widely expected to remain soft for some time. There are still some serious headwinds (lingering problems in residential and commercial real estate, substantial budget shortfalls in state and local governments, uncertainty over tax policy, and a decreasing fiscal stimulus in 2011).
The likely effectiveness of further purchases of long-term securities is an item of debate among Fed officials. Large-scale purchases of Treasuries and mortgage-backed securities were critical during the financial crisis. However, further efforts are likely to be less effective now that conditions are more normal. Some Fed officials see problems as being more structural rather than cyclical, which would mean that policy stimulus would have less of an impact (recovery, in this case, would be largely a function of time). However, most view the current softness as cyclical (in which case, stimulus would be more meaningful).
The Wall Street Journal has reported that Fed officials are considering smaller-scale asset purchases. During the financial crisis, the Fed announced plans to purchase very large amounts of assets over many months. In contrast, the Fed may now adopt a more flexible strategy, announcing plans to purchase smaller amounts over shorter periods (a month or two). This is likely to make it easier to get those Fed officials sitting on the fence to go along – and the Fed could pull back if the pace of recovery were to pick up. The question then gets back to timing. All else equal, the Fed does not want to appear as being influenced by politics. The next FOMC decision is due on November 3, one day after the mid-term elections, but before the release of the October Employment Report.
Copyright (c) Raymond James
