Friday, August 24, 2012

The Fed & the Cliff

Evel Knievel was an American daredevil, who attempted over 75 ramp-to-ramp motorcycle jumps between 1965 and 1980. In 1974, he failed in his attempt to jump across Snake River Canyon in a rocket. He survived, and died in 2007 of pulmonary disease. Fed Chairman Ben Bernanke may be about to try to outdo Knievel with an even greater stunt: attempting to leap over the fiscal cliff at the beginning of next year.

I think there’s a chance that he might announce during his August 31 speech at Jackson Hole that the Fed will launch an open-ended QE3 program with the hope of turbocharging the economy so that it can leap over the cliff. San Francisco Fed President John Williams, a voting member of the FOMC, was the first to advocate this stunt in an interview reported in the 7/23 FT.
He floated the idea again in an interview reported in the 8/10 issue of the San Francisco Chronicle. When he was asked whether QE3 should be saved to cushion the fall off the cliff early next year, if necessary, he responded: "We want to position the economy to be strong in advance of that. If you are really worried about running out of ammunition, you want to act more aggressively, more quickly and better prepare yourself for that eventuality."

Boston Fed President Eric Rosengren, who is a non-voting member of the FOMC, seconded Williams’ motion for open-ended QE3 in an interview reported in the 8/7 WSJ. According to the minutes of the July 31-August 1 FOMC meeting, released yesterday, "Many participants expected that such a [QE] program could provide additional support for the economic recovery both by putting downward pressure on longer-term interest rates and by contributing to easier financial conditions more broadly."

Since bond yields are already at record lows, could it be that Fed officials have concluded that the only transmission mechanism they have left between monetary policy and the economy is the stock market? Recall that the Fed Chairman mentioned stock prices twice in his 11/4/10 Washington Post op-ed explaining why the Fed implemented QE2 the day before: “Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. … And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”

Michael Oliver, a seasoned stock market technician and a good friend, asks an interesting question about Bernanke’s highly anticipated stunt: “Prior [Fed] interventions came at market lows when the technicals were oversold, hence ripe for some upside relief. So, with that ‘difference’ this time around, with the market if anything technically stretched and measurably overbought on the upside, will a new QE work or blow up in their face?”

Great question. All the more reason to save the big QE3 stunt for early next year, if necessary, in my opinion. For now, why not just extend NZIRP until the unemployment rate drops below 7%? The FOMC discussed such a policy option at its last meeting:
“Given the uncertainty attending the economic outlook, a few participants questioned whether the conditionality of the forward guidance was sufficiently clear, and they suggested that the Committee should consider replacing the calendar date with guidance that was linked more directly to the economic factors that the Committee would consider in deciding to raise its target for the federal funds rate, or omit the forward guidance language entirely.”

If nothing is done by Congress to avert the fiscal cliff at the start of next year, the Congressional Budget Office (CBO) projects a recession during the first half of next year, with the unemployment rate remaining above 8% through 2014: “The increases in federal taxes and reductions in federal spending, totaling almost $500 billion, that are projected to occur in fiscal year 2013 represent an amount of deficit reduction over the course of a single year that has not occurred (as a share of GDP) since 1969. ... Real GDP is projected to fall at an annual rate of 2.9 percent in the first half of next year and then to rise at an annual rate of 1.9 percent in the second half.”

“The magnitude of the slowdown we’re discussing next year is significant,” CBO Director Douglas Elmendorf said at a morning briefing on August 22. He warned that going over the cliff could cost the nation about 2 million jobs.

In any event, the latest FOMC minutes noted: “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.” There was no similar comment about taking action "fairly soon" in the minutes of the previous meeting during June 19-20.

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