The market is split over whether or not the Fed will activate another quantitative easing programme. To try and clear up some of my queries I deferred to those smarter than I and canvassed our analysts in economics, rates strategy and asset allocation. It seems reaching a consensus will be difficult. Please see below for their thoughts.
1) Stephen King, Chief Economist
The chances are not high, although may have risen a little in recent months. The chances are not high for two reasons, 1, because there are concerns about how QE actually works, and 2, last time around there were genuine concerns on deflation. This is not the case this time, so it’s likely the Fed will take the view we are not in a “Japan-like” scenario and so will keep their powder dry.
2) Steve Major, Global Head of Fixed Income Research
I believe there is less than a 50% chance of QE3 for two reasons:
1. The US economy is not in as dire a shape as it was for QE1 and QE2. The Fed will not want to use a silver bullet until it is clear there is a new deflation risk.
2. The political backdrop is not favourable. There is an election next year and already there is polarisation over issues like further stimulus, whether it be fiscal or monetary. Also my understanding is that Dodd-Frank will make it more difficult to enact QE3. The Fed cited ‘exigent’ circumstances in starting QE and did it without need of approval from Treasury and Congress.
3) Kevin Logan, Chief US Economist
There is perhaps a 20% chance of QE3. It could occur if inflation starts to fall and the unemployment rate moves higher. But we do not expect that particular combination to occur.
The Fed embarked on QE2 because of its concern about deflation. Last year the rate of core inflation was falling (from 1.5% in July 2009 to 1.0% in July 2010; it eventually reached a low of 0.6%). High unemployment might have led to persistent declines in inflation. Now the situation is different. The core rate of inflation has moved up from 1.0% in April last year to 1.3% in April this year. It will probably move higher as the year goes on. So one of the prime reasons for pursuing QE has faded. Unemployment is also lower than last summer (9.1% rather than 9.6%). Fed officials felt that the potential trade-off between lower unemployment and potential increases in inflation are not as favorable as they were last year. With inflation at 1.0% and falling it was okay to risk a one percentage point increase in inflation. With inflation at 1.3% and rising, there is a risk they could push inflation up to and over the 2.0% target. They want to avoid that.
However, with weak economic growth apparent over the last several weeks, it is likely that the Fed will delay any near-term move to reduce monetary accommodation. That is, they will continue to reinvest the proceeds of their current investments. Ceasing to reinvest principle payments will probably be the first step toward less accommodation. By continuing to reinvest, the Fed is implicitly promising to keep the fed funds rate lower for longer.
If QE3 were to occur, I think it would just involve more purchases of Treasury securities. Some have suggested the Fed could buy more MBS, but they generally would prefer to follow a Treasury only policy. There would have to be a real disaster occurring in the market for MBS to bring on renewed purchases in that sector.
Consequences? Probably only a modest effect. The gas tank is already full.
Putting in more liquidity would only cause it to overflow. The economic motor is only going to start moving when the growth of credit picks up – and that depends on the demand for credit more than the cost or availability of credit at this point.
4) Fredrik Nerbrand, Global Head of Asset Allocation
We aren’t just going to see QE3, we are going to see QE6 and beyond. If there is any external economic shock to the US, and there will be one, the Fed will fall back on QE because they have nothing else in their arsenal. As long as the US does not generate any real job growth they will continue to choose the easy route of QE to attempt to boost the economy. Some of the reforms enacted in Europe, for example dealing with entitlement programmes, also need to be put in place in the US. Until this is done the economy will not be able to get back on a firm footing and we will continue to see QE programmes.
5) Larry Dyer, Head of US Rates Strategy
With inflation measures relatively high, I think the near term odds of QE3 are quite low.
But, the bond market may price in QE. So, answering a somewhat different question, I think the odds of the market pricing in QE3 are 30% or so.
Price moves tend to reinforce themselves and a follow on set of slow economic numbers would push yields lower.
6) Bob Lynch, G10 FX Strategist, NYC
Bob has taken a slightly different tack and recently published a report entitled ‘The politics of QE3’ as he looks at how congress is split over QE3. I have attached the note.
* Ultimately further easing will depend on economic conditions and crucially inflation and the unemployment rate
* While some in Congress oppose further easing, there are many who would not object
* Were QE3 to become likely, the USD would ultimately suffer
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HSBC Global Research