Potential, Risks & Incompleteness of the QE2 Solution

by Rick Reider, Chief Investment Officer, Fixed Income, BlackRock, Inc.

Highlights

• Economic indicators continued to deliver “mixed messages” in October, as policy anticipation drove markets in advance of both the elections and monetary policy
• Beyond reaffirming its decision to maintain historically low Fed Funds policy rates, the Federal Reserve announced expansion of its balance sheet via quantitative easing.
• With an eye toward managing inflation expectations, the Fed embarked on this path, but it could have negative consequences in the absence of a fiscal complement.

Economic Review and Outlook

As market participants awaited both the mid-term US Congressional election and the Federal Reserve’s expected announcement of further quantitative easing (“QE2”) in early November, economic data released in October remained mixed. For instance, both retail sales and retail sales/ex autos beat economists’ consensus estimates at 0.6% (versus 0.4% expected) and 0.4% (versus 0.3% expected), respectively. Also, one significant upside surprise for the month was the improvement in the ISM Manufacturing data print (56.9 versus a consensus forecast of 54), which rose to its highest level since May 2010. Yet, while manufacturing has been an area of the economy displaying some encouraging signs, considerable improvement from here is still required to return to more “normal” levels. For example, manufacturing capacity utilization has remained under 75% since the height of the financial crisis in late 2008, and while it has recovered meaningfully since its trough in mid-2009, the current level of 74.7% is still nearly six percentage points below the average rate from 1972 to 2009. That slack in the economy goes a long way toward explaining subdued inflation, as core CPI (excluding food and energy) reached a current cycle low of 0.8%.

Federal Reserve Outlook

As the Federal Open Market Committee (FOMC) meeting concluded with the announcement of a second round of quantitative easing, the Committee stated its intent: “to promote a stronger pace of economic recovery and to help insure that inflation, over time, is at levels consistent with its mandate [therefore]… the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.” The Fed’s Treasury purchases should compel investors to move capital further out the risk spectrum, which could potentially support fixed income spread sectors as well as equities. Part of the Fed’s intent, we would argue, is not only to attempt to unlock capital that has been sidelined through the recovery, but also to lift risk asset prices to combat the wealth destruction resulting from the financial crisis.

Market Outlook

Some have questioned the need for Fed quantitative easing at this stage in the recovery, and there certainly are some concerns over the unintended consequences of using less orthodox policy to stimulate the economy. Still, what is often lost in these debates is the fact that in the absence of easing, in this economic environment, monetary policy would effectively be tightening at a precarious time for the recovery. In fact, we think that quantitative easing is clearly needed to support the recovery given the significant structural headwinds that we have discussed in the past. While the Fed’s program of asset purchases will not be able to lower unemployment directly, what it can do is support risk assets by creating a positive wealth effect (which can lead to greater organic spending growth), and it can alter inflation expectations, all with an eye toward ultimately creating higher levels of employment.

While Fed policy pursues a laudable goal, the task of managing inflation expectations is an extraordinarily difficult and complex operation to undertake. Indeed, the Fed is attempting something that really has no historic precedent, and different segments of inflationary consumption baskets (and industry areas) can respond very differently one to another as changes in the general price level are realized. Thus, for example, when looking at inflation baskets in the United States over the past decade, we find that the cost of tuition has more than doubled since the end of 1997, but media recording costs have nearly been cut in half. Of course, this is partly due to the new technologies and distribution methods in the media industry, but the variability by basket segment is remarkable. Another key consideration to keep in mind is that Fed policy shifts of this kind have significant implications for the global economy as well. In fact, due to the large number of countries that manage their currency regimes by “shadowing” the US dollar, one can argue that the Fed essentially sets monetary policy for almost 44% of global GDP (the United States included), a powerful global lever. Thus, a persistently dovish Fed clearly creates a stimulative global impact through a weaker dollar, and that has a very high inverse correlation (see graph) with global capital velocity and increased foreign exchange reserves. This has recently raised tensions between the Fed and some impacted central banks, but the Fed has to manage to meet its dual mandate of full employment and price stability.