In a speech about the US Economic Outlook, Fed Chairman Ben Bernanke offered a litany of reasons why the FOMC will consider easing monetary policy further when it meets later this month on 21 September. He noted that there are “persistent” factors holding back the economic recovery that are not likely to fade soon. He also downplayed the threat of higher inflation; instead suggesting that inflation will “moderate” in coming quarters as ongoing weakness in the labor market and subdued labor costs restrain inflation pressures. The question now is what “unconventional” easing option the FOMC will take up next.
SOBER ASSESSMENT OF ECONOMIC OUTLOOK
Mr. Bernanke presented a very sober assessment of the outlook for the US economy today. In the process he implicitly endorsed growing expectations in financial markets that the FOMC will adopt further measures to ease financial conditions at the upcoming policy meeting on 21 September. Importantly, Bernanke noted that the Committee now expects a slower pace of recovery than it did earlier this year, “with greater downside risks to the economic outlook.”
Household spending has been much weaker than Bernanke and his colleagues at the FOMC were expecting. They (along with most other economists and analysts) under-estimated the drag imposed on consumer spending by high debt burdens, falling house prices and sluggish gains in wages. Moreover, households appear to have become more pessimistic lately as they begin to doubt the ability of the economy to bounce back as it normally does after recessions. The sluggish recovery means a longer period of slow income gains and retrained increases in financial wealth. All of this holds back consumer spending and keeps the economy from heating up.
The economy’s problems do not stop there. Bernanke also suggested that the toxic combination of a deep housing slump and financial crisis have acted to “slow the natural recovery process” in the economy. Housing construction is at less than one-third of its pre-crisis peak, depressing the growth in demand for a wide range of goods and services related to homebuilding. Delinquent and “underwater” mortgages create financial hardship for many households and increase stress on financial institutions as well, further restraining the growth of credit. Financial stress extends to government finance as well, forcing cutbacks at the state and local government level and heightening concerns about the long-run fiscal health of the federal government.
All of these problems paint a picture of an economy that is going to growth slowly at best. More worryingly, the economy is vulnerable to another recession, one that would only exacerbate the problems in the housing sector and in the government fiscal position. In these circumstances, it would seem appropriate for the Federal Reserve to ease monetary conditions as much as possible, both to protect against a slide back into recession and to promote a faster rate of economic growth.
Inflation could be a barrier to further monetary ease, but Bernanke downplayed this concern. He stated that the rise in inflation earlier this year was mostly due to transitory factors that are already beginning to fade. Mr. Bernanke and his colleagues continue to believe that longer-term inflation expectations are stable, citing evidence from consumer surveys, from the market for inflation-adjusted bonds and from forecasters’ surveys. He stressed that weakness in the labor market is holding down increases in unit labor costs and acting as an “important” restraint on inflation.
PREPARED TO PROMOTE A STRONGER RECOVERY
With a weak economic outlook and “subdued” inflation, Mr. Bernanke strongly hinted that the FOMC is “prepared” to provide the economy with additional monetary stimulus – beyond that already provided through a near-zero fed funds rate and “quantitative easing” that more than doubled the Fed’s balance sheet over the last two years. A range of possible policy tools were discussed at the August FOMC meeting. Four possibilities were given explicit consideration.
The first potential tool is offering verbal “guidance” on the duration of monetary ease linked to economic conditions (such as the level of unemployment). The second would be additional asset purchases (QE). However, recent press reports suggest that there is not strong support on the Committee for these two alternatives at the moment.
TOP OF THE LIST
A third possible tool would be to increase the average maturity of the Fed’s securities portfolio by selling short-term securities and re-investing the proceeds in longer-term securities (a maneuver that has been dubbed “Operation Twist”). This alternative appears to have moved to the top of the list of preferred policy actions. It would not involve an expansion of the Fed’s balance sheet, just a rebalancing of its portfolio, and so might mute potential criticism of the sort that greeted the QE2 easing program last year.
The Fed has about USD500bn in Treasury securities with maturities of 3-year or less. These could be sold and re-invested in debt with maturities of seven years or more, with the intent of putting further downward pressure on long-term interest rates. If Treasury rates fall far enough, rates on home mortgages could also decline appreciably, providing some support to house prices and allowing for an improvement in household balance sheets through mortgage refinancing.
The economic impact of an Operation Twist would probably be small. With average house prices still in a modest downtrend, potential buyers still see higher than normal risks in the housing market. Tighter credit standards and “underwater” mortgages are holding back an expansion of mortgage refinancing. Lower mortgage rates will not necessarily change this situation substantially, nor would it promote a strong surge in housing demand. However, these considerations will not prevent the FOMC from acting. Any action at this point would be judged as better than doing nothing. Indeed, the possibility of lower rates could boost consumer confidence a bit and might prevent a further slowdown in consumer spending.
CUTTING INTEREST PAID ON EXCESS RESERVES
Reducing the current 25bp paid on excess reserves held by banks is a fourth policy option and one that might be given strong consideration at the 21 September meeting. A few months ago, the rate paid on excess reserves did not appear to be an important policy tool because it was already well below yields on short- and medium-term Treasury securities. Now, however, the yield on the Treasury 2-year note is only about 20bp and yield on the 5-year note is about 90bp. Banks are now earning more on the cash they leave at the Fed than they would earn investing in 2-year Treasuries. Cutting the rate paid in excess reserves to, say, 15bp, would probably put some downward pressure on 2-year to 5-year Treasury rates and offset some of the upward pressure that would come from sales of those securities if the FOMC did engage in an Operation Twist. The combination of maturity extension and a lower rate paid on excess reserves would probably be a more powerful action than either one in isolation.
BOTTOM LINE
Mr. Bernanke has not promised additional monetary easing. In fact, he cannot do that unilaterally. The decision to change policy is up to a majority of the policymakers at the FOMC. However, Bernanke laid out the case for additional action and hinted strongly that further easing could come at the September policy meeting when he said that the Fed “will certainly do all that it can to help restore high rates of growth and employment…”
At this point, we expect that the FOMC will take further easing action at the 21 September meeting, mostly likely through a decision to extend the average maturity of its portfolio of Treasury securities. A reduction in the interest rate paid on excess reserves from its current 25bp to about 15bp is also a strong possibility.
Kevin Logan
HSBC Global Research