More Twist and Still More Pumping Measures Waiting in the Wings
The June FOMC meeting was the first in which the two new members of the board of governors (the 7-headed hydra in Washington the members of which have a permanent vote on the FOMC), Jeremy Stein and Jerome Powell took part.
It is quite funny in hindsight that the Republican Congress refused to confirm several previous candidates to these posts on the grounds that they were 'old style Keynesians' or otherwise suspected of being prone to leaning toward more easy money.
As it turns out, the two new appointments which eventually found favor with these Congressional defenders of monetary rectitude are among the board's most dovish members. This was gleaned from the projections of board members regarding the speed with which they expected monetary tightening to become necessary.
„ Both new Fed board members—Democratic economist Jeremy Stein and Republican businessman Jerome Powell—appear to be in Chairman Ben Bernanke's more dovish camp. Notably, the Fed's projections showed that an additional two board members don't expect the Fed to tighten policy until 2015.“
If Japan's experience over the past two decades is any indication, even that estimate will prove to be wide of the mark.
As was widely expected, the FOMC decided to extend its 'Operation Twist', although one wonders what for. With the 10 year treasury note yield close to all time lows, what is to be gained from this?
On the other hand it was difficult at this time to engage in more foreceful monetary pumping measures. There are political headwinds that require the Fed to come up with a very good excuse if it wants to start 'QE3'. Such an excuse would be provided by a sharp fall in the stock market, or a noticeable further deterioration in economic data.
So what is the extension of the relatively useless 'Twist' program telling us? It says: we want to print. Even if we can't go whole hog yet, we'd rather do something that is useless even from our own point of view, rather than doing nothing.
This was further buttressed by the changes in the FOMC statement and its altered economic outlook. Well-versed Kremlinologists at the WSJ have constructed a 'Fed statement tracker' that allows one to parse the FOMC statement in detail and see the changes relative to the previous statement at a glance. As can be seen, there are a number of notable differences this time around, all reflective of a downgrade of the Fed's economic forecast and hence hinting at more monetary pumping down the road.
The economic forecasts and estimates regarding the future path of policy of individual board members can be seen here (pdf).
Widely Accepted Fallacies
During the press conference, Bernanke was once again frequently asked 'why isn't the Fed doing more right away'. After all, its statement and forecast indicate that is expects no further improvement in the labor market for the rest of the year. There are no journalists at that press conference who doubt the wisdom of central planning or have the slightest suspicion that more money printing could be anything but a boon for the economy. This is the level to which the discourse on monetary matters has regrettably sunk nowadays. It is assumed as a matter of course that if only enough money were printed, the economy would surely get better.
Bernanke's replies to these questions all hinted at his willingness to do just that. We strongly suspect that among the reasons why the FOMC has not yet decided on more forceful pumping measures in the form of 'QE3' or something akin to it there is not only the current political difficulty of doing so.
There is also the fact that there is at the moment no real crisis in the US financial markets and economy. However, there is a crisis in the euro-area, and the danger that it could migrate and trigger crises elsewhere is great. So if the FOMC were to embark on 'QE3' right now, the question would then be:
How to top that if a real crisis were to strike, with the stock market crashing and interbank markets freezing up again?
Moreover, Bernanke pointed to some of the limitations faced by the Fed. For instance, 'QE2' removed a large amount of treasury bonds from the marketplace. However, it is precisely these treasury bonds that are the favored collateral in repo transactions. There is at present a 'shortage' of AAA rated assets that can be used for such transactions. Obviously, the higher rated the collateral, the smaller the haircuts and margin requirements demanded by liquidity providers. The Fed's 'QE' operations were both accompanied by big spikes in 'fails to deliver' in the treasury market. There can be no doubt the Fed is well aware of this.
There is of course something quite perverse about a financial system that requires government debt of all things to function properly, especially considering that this debt has grown to truly monstrous proportions.
The bigger the role of government in the economy, the more wealth is destroyed. A productive loan that is invested in new capital to increase production or start a new line of production with the aim of satisfying consumer wants increases wealth (leaving aside that due to the uncertain future a certain percentage of productive lending will come to grief).
A loan to government is not based on such a prospective increase in wealth to ensure payback, but on its opposite.
The government merely promises its lenders: “we will either confiscate someone's wealth to pay you back or simply print the money – or both”. Obviously neither of these methods is likely to grow society's wealth. And yet, these certificates of confiscation have become an important pillar underpinning the modern-day financial system.
The idea that the Federal Reserve can improve our economic lot by printing more money is an analogous fallacy – just as more government spending is a burden rather than a boon for the economy, so the printing of more money can not add anything to our wealth. It is the production of goods and services that increases wealth. Printing additional money tokens (or creating their electronic equivalent in cyberspace) is only apt to distort relative prices and will therefore lead to capital malinvestment. And yet, listening to Mr. Bernanke's press conference and the questions asked of him, one comes away with the impression that absolutely no-one in the financial press doubts that we can print ourselves rich.
One thing the financial press has however without a doubt gotten right is that the extension of 'Operation Twist' is merely an opening gambit before additional pumping measures are announced.
“It is unlikely that the Federal Reserve's efforts to boost the economy will end with "Operation Twist."
The Fed's rate-setting committee decided Wednesday to extend its so-called Twist operations. These involve it selling short-term Treasuries and using the funds to buy long-dated ones. The goal is to bring down long-term interest rates.
The extension of Twist assuaged markets, which had expected action along those lines. But the Fed also lowered the bar for further efforts, noting in its statement that it was ready to do more to promote "a stronger economic recovery and sustained improvement in labor-market conditions." And, in projections released shortly afterward, the Fed said the central tendency of board members' year-end unemployment estimates ranged from 8% to 8.2%, versus the 7.8% to 8% they expected in April. The unemployment rate last month was 8.2%.
So, to sum it up, the Fed wants a better job market. And the Fed doesn't think that the job market is going to show much, if any, improvement through the end of the year.
Absent a turn for the better between now and the Fed's two-day meeting July 31 and Aug. 1, it looks as if more action could be in the offing. That would likely involve a third round of quantitative easing, or QE3, involving outright purchases of Treasuries and, especially, mortgage-backed securities.
The hawks on the Fed will complain, and with rates at rock-bottom levels already, the efficacy of further action is indeed open to debate. But they are now more outnumbered than ever.
As to the 'hawks' at the Fed, all of them are district presidents who don't have a permanent FOMC vote. Furthermore, there are so few of them that one can count them on the fingers of one hand. They are Jeffrey Lacker (Richmond Fed), Richard Fisher (Dallas Fed), Charles Plosser (Philadelphia Fed) and to a lesser extent Nayarana Kocherlakota (Minneapolis Fed). Only Jeffrey Lacker has an FOMC vote this year, and he has been the lone dissenter in all decisions so far taken this year. With two new 'doves' added to the board of governors in Washington, it is indeed a good bet that all the grumbling of the 'hawks' will be for nought.
An important additional point worth mentioning with regards to the Fed's economic forecast is that it not only sees unemployment remaining very high, it also has lowered its 'inflation' estimates considerably (i.e., its estimates of the future increase of the 'general price level' as measured by CPI and/or PCE). This is important because it creates the intellectual wiggle room for further monetary easing. One question Bernanke fielded during the press conference was whether he wouldn't agree that 'QE2' failed to produce any of the desired effects. His reply was revealing – he essentially conceded that the results were somewhat disappointing, but asserted that it was still worth doing. The reason: it helped 'avert the danger of deflation'.
Nonetheless, the financial markets were less than happy with the FOMC announcement. Both stocks and commodities, including gold have trended lower ever since, although the stock market attempted a comeback late in the day yesterday. It appears the markets had primed themselves for a 'QE3' type announcement and since that was not forthcoming, sellers merged. This is slightly mysterious to us – it should have been clear to market participants that no such announcement would be forthcoming at this particular FOMC meeting. There simply was no justification for taking such a step now and the Fed doesn't want to become the center of attention in an election year – it may well be accused of trying to influence the election, a charge it is no doubt eager to avoid (as a matter of fact, such an allegation would not have any merit anyway in our opinion, but this is beside the point).
The SPX intra-day yesterday: first elation, then disappointment, then a small comeback attempt - click chart for better resolution.
SPX – the first 90 minutes of trading today – selling resumes - click chart for better resolution.
The past five trading days in gold (including the first half of today's trading) – whatever enthusiasm there was – and as we have pointed out there wasn't much to begin with – has gone out of it again. The consolidation/correction continues for now - click chart for better resolution.
Crude oil also continued to fall on very high trading volume – click chart for better resolution.
As can be seen, the markets these days only rally when there is a firm commitment to more money printing. 'Twist' influences bond yields at the long end of the curve, but it does not add to the money supply.
Charts by: BigCharts, StockCharts, Comdirect
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