U.S. economic activity continues to disappoint; real GDP growth is currently tracking slightly below 2% in the second quarter which means that the unemployment rate is unlikely to drop any further this summer. Meanwhile in May headline CPI inflation dropped to 1.7%. Consequently weaker data and sliding equity prices have reignited market expectations that the Fed will provide more stimulus.
While we certainly believe that the Fed eventually will ease monetary policy again, the big question is whether the Fed will embark on monetary easing already at the current meeting or – shades of 2010 and 2011 – wait for a few meetings. Some FOMC members have shown appetite for monetary easing; notably vice-chair Yellen recently said that there was a case to manage downside risks. Her remarks were at some odds with Bernanke who at his Congressional Testimony on July 7th argued that the slowdown has been exaggerated and that growth will continue at a moderate pace.
So what will the next monetary easing program look like? A light version would be a short extension of Operation Twist for a few months or extending the forward guidance into 2015. But since the short term assets left to sell are very limited, extending the Twist is not a very potent tool right now. If the Fed actually decides to act preemptively, for example on the crisis in Europe, a new round balance sheet expansion (QE3) via mortgage buying is the most likely option in our view. If the recovery continues to disappoint there are other easing options too; remember that back in 2002 Bernanke recommended that at the zero bound the central bank could announce an explicit ceiling for long-term bond yields which could push bond yields to even lower lows. The Fed could also promise not to raise the fed funds rate until the unemployment rate has fallen to specific level (the Evans proposal).
It is a close call, but our baseline scenario is that the Fed won’t act tomorrow already. That being said, via a dovish statement and downgrades to the growth prospects the FOMC may well prepare the way for QE3 at the next meeting. If the Fed decides against QE3 now, the forward guidance should be extended into 2015 in our view.
The Fed will present updated forecasts and growth prospects will probably be downgraded again, but the forecasts are expected to remain above consensus.
Mattias Bruér, SEB Economic Research