Testimony
Chairman Bernanke delivered his testimony to the Committee on Financial Services in Congress this morning. There won’t be many surprises in the testimony for those who have been following our Market Updates. Much of what was delivered was a re-hash of prior speeches from the various Fed Presidents.
One of the most obvious traits of recent Fed speeches has been the idea of “transitory” or “temporary” setbacks for the economy. Everyone acknowledges that the pace of the recovery is “moderate”. The Fed strongly believes that most of the factors that are currently dragging on the economy are temporary in nature and they are doing much of their planning on that assumption. If that assumption proves to be incorrect then they will have to make significant adjustments to their plans.
What if we weaken?
A few courses of action have been mentioned recently as potential responses to deterioration in our economic prospects (i.e. if our current obstacles turn out to be something less than transitory).
The first plans is that the Fed could tell us in more explicit terms what “extended period” means and how long they will keep their balance sheet at current levels. This one makes me laugh a bit because it implies that they’ve been intentionally avoiding the topic so far. It’s like when the wife asks me if I want to go see the new chick flick at the theatre. My standard response is to initiate a round of delaying tactics. It’s always easier to delay answering the question until her girlfriends arrange a girls-night-out to the movies rather than take the hit on my own. I usually say something like “let’s talk about it later…” and then I sneak off to the garage. If the situation deteriorates (i.e. she gets more persistent about it) I can provide her with more detailed guidance on the odds of me going to that movie…but if I’m not forced into that spot…why put myself there? So that’s the Fed’s first tactic for dealing with adverse economic developments …we’ll call it the “Chick-Flick strategy” of monetary policy…where they only provide more guidance on intentionally vague statements against their will.
Another tactic mentioned was to reduce the 25 bps that the Fed is paying on reserves held with them. They don’t mention the magnitude of the impact they expect this action to have…most likely because it will be immaterial.
Finally the FOMC minutes that came out earlier this week mentioned that a minority of the members were in support of QE3 if conditions deteriorated. I guess they didn’t want to name names but we know that Minneapolis Fed President Kocherlakota has already gone on record as saying a drop in PCE (the Feds preferred gauge of inflation) from his 2011 forecast of 1.50%, along with unemployment remaining elevated would be a trigger point for considering QE3. There doesn’t appear to be a huge following at the FOMC for more Quantitative Easing. Everyone acknowledges that at the start of the program they didn’t expect spectacular results…it was a big program which at its best was expected to deliver marginal results. The Fed has acknowledged that monetary policy has its limits…and QE2 was pushing them, so I don’t expect a huge appetite for more quantitative easing in the near term.
Keep in mind that the Feds dual mandate is to foster maximum employment and price stability. They have to be feeling more than a bit insecure about their performance on these fronts so far. I’m not trying to imply that monetary policy has all the cures for these issues because it certainly doesn’t. The point is that the Fed is the only entity standing in the spotlight trying to fix these issues and so far the economy is about as squared away as a soup sandwich. Month after month they spend more money and things don’t get better. At this point they’ve got to be feeling like Rodney Dangerfield…they’re not getting a lot of respect.
What if we strengthen?
In the best case scenario where all of the obstacles turn out to be transitory and the economy finds itself picking up steam with people going back to work and inflation on the rise, the Fed will be in a spot where they have to tighten. With the tangled network of programs that currently exist there have been a lot of questions regarding HOW they will tighten if and when the time arises. Questions such as:
- Will they raise the overnight rate first?
- Will they sell bonds out of their portfolio?
- What will they do with their portfolio cash flows?
- Will they execute these steps concurrently?
- Do they favor one tactic over another?
Bernanke said today that the FOMC has reached a “broad consensus” on how they will begin tightening monetary policy once they decide that it’s the appropriate time. Those steps are listed below. Print this off and tape it to your wall.
1 – They will stop reinvesting their portfolio cash flows
2 – At the same time (or shortly after) they will change the guidance in the FOMC statement
3 – Initiate temporary reserve draining operations
4 – Raise the Fed Funds target rate
5 – Sometime after they’ve begun raising rates they will begin outright sales from the portfolio
At the end of this road they would be in a spot where the Fed Funds target rate has been returned to its normal role as the primary driver of monetary policy. You have to have a plan…and that is the one the Fed has come up with. The timing of any such plan will of course be “data dependent”.
The item that jumps out at me immediately is that “raising the Fed Funds rate” is pretty far down the priority list. So not only does the economy have to see huge improvement before we get to a point where tighter monetary policy is appropriate…but once we get there you won’t be getting immediate relief from the pain of selling Fed Funds.
That’s all for today. If you have any questions or if there is anything I can do just let me know.
Steve Scaramastro, SVP
800-311-0707
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