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This Week’s Macro View

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    September 6, 2011

    The majority of major economic data is now in prior to the next FOMC meeting with the exception of  ISM Services on Tuesday September 6. Since Bernanke spoke at Jackson Hole a great debate has begun on how to “avoid another great recession.” Everything from “operation twist” to QE3 has been discussed and in many ways this is a healthy debate.

    The more involved often the better ideas that are generated. Right now this economy needs a miracle which is highly unlikely but at least it’s better to expand the conversation beyond a group of FOMC academics (Fisher perhaps the one exception). So the big question, what is the Fed to do? Well they have two options.

    Option 1 Expand The Balance Sheet

    The Fed would simply buy more assets by printing money (excuse me creating, Treasury prints the actual money) and purchasing assets on the open market as they did under QE1 with Mortgage Backed Securities (MBS) and QE2 with treasuries. The problem with such an option is the controversy around the prior two programs and the questionable success of such action. Additionally with the current inflation risk a prolonged campaign such as six months would be rather difficult to launch.

    Perhaps the Fed would agree to a monthly campaign of $100 billion for example and regularly evaluate future purchases. Although possible this option seems less probable. The biggest concern would be what do they buy? In buying treasuries they are hurting the repo market by removing high quality collateral needed to facilitate lending. Perhaps they could purchase more MBS but their balance sheet is already at risk with such high exposure. I’m unsure if they can buy municipal debt and would imagine they cannot buy corporate debt.

    Option 2 Adjust The Duration Of Existing Holdings

    The Fed would change the maturity of their holdings and not expand the balance sheet. For example if they were to sell two year treasuries and buy ten year they would be extending that portion of their balance sheet by eight years or less on a weighted basis.

    There are limitations though to do this. The flatter the yield curve (i.e. the difference between the 10 year and 2 year yields) the more banks are theoretically hurt as it would impact their ability to generate interest income. One can argue though with the federal funds rate at 0-25 bp for two years the two year and shorter maturities will still stay historically low. The biggest risk though is that of inflation. Below is an analysis of inflation expectations, CPI and the yield curve.

    Inflation Expectations

    Inflation expectations have fallen considerably over the past 30 days with the average across maturities approximately 2.1% which is the upper range of the 1-2% target rate. By contrast in August 2010 when the Fed announced QE2 at Jackson Hole the average inflation expectation was 1.6%. Measured by TIPS the risk of deflation although low compared to 2010 is rising.

    Actual Inflation (CPI)

    Inflation risks as measured by CPI show deflation was in fact a risk in the summer of 2010 and then reversed in July and August and has been trending higher since with inflation now the real risk. There is also a lag time between monetary stimulus and its affect on actual prices. It is quite probable that even with QE2 now ended that CPI will continue to trend higher.

    Treasury Yield Curve

    Between the end of QE2 and August 31, 2011 the yield curve has flattened rather substantially with the major source of flattening in the longer dated maturities, primarily 10′s and 30′s. This would make the argument that the bond market is doing the heavy lifting of QE3 by lowering long term rates. In other words would further changes to Fed balance sheet duration cause more harm to banks.

    When you look at the yield curve though between August 31 2011 and August 31, 2010 when the Fed began a program to lower long term yields under QE2 it is interesting to note an identical shape in the curve. So in this case one can argue that the Fed has some room to adjust the duration of their balance sheet having seen how such a curve has had minimal impact on banks.

    I won’t try and pretend to forecast what the Fed will do in a few weeks. I must admit they scare me in terms of their reckless action at times. An example of such comes from a recent interview with Chicago Fed President Evans who in March was predicting 4% GDP growth in 2011 and 2012 (in Q1 his estimate was off by 1,000% with GDP at 0.4%). When asked about monetary policy’s ability to improve the labor market he completely ignored the reality that a vast majority of jobs lost are related to housing which is structural and not coming back for many years. He felt monetary policy could in fact bring back those jobs.

    I do believe the Fed has far less options available to them. They will act if forced no question about it. Heaven help the markets if they in fact are out of bullets and fail to do anything in the coming weeks especially if economic data continues to deteriorate.

    From Macro View September 5, 2011- Macro Story.

    Images: Flickr (licence attribution)

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