Fed: The Great QE Debate of 2010
Quantitative easing will continue inspite of the risks
By Sassan Ghahramani*
The US Federal Reserve, unlike central banks with single inflation mandates, was tasked by Congress, through the Federal Reserve Act of 1913, with the "dual mandate" of targeting both full employment and stable prices.
The market rise and crash of 2007-8, now referred to as the start of the "Great Recession," has opened this Fed decision making framework up to criticism from other, more orthodox, inflation targeting central banks as resulting in overly activist monetary policy.
Furthermore, some critics who are actually in favour of the dual mandate nevertheless accuse the Fed of seeming in the past to have overly emphasised the growth and employment mandates, at the expense of the price stability mandate.
This, they say, led directly to what many are calling a Greenspan-fueled bubble, and crash, of the real estate and financial asset markets.
Much to the dismay of these critics, Fed Chairman Ben Bernanke has now indicated that he wants to pursue a second round of aggressive easing, at zero interest rates, through a new program of Treasury security purchases, referred to as quantitative easing, or QE.
This has triggered the Great QE Debate of 2010, with a new round of criticism that can be broken into two broad categories:
The ineffectiveness argument, namely that with businesses and consumers unwilling to invest or spend further, lowering rates through additional bond purchases will not be effective in growing the economy, or in common parlance, simply be "pushing on a string," and worse.
The negative consequences argument, namely that a further expansion of the Fed balance sheet through bond purchases will come back to haunt the Fed through spiraling inflation, another asset bubble that collapses as compressed rates push investors farther and farther along the risk curve, and an unwind of a huge Fed balance sheet that tanks bond markets when the time comes.
That is why the September 21st Federal Open Market Committee meeting was so critical for Chairman Ben Bernanke. At that meeting, he had to argue his case for further QE and somehow work to bring along, if not neutralise, opponents of further QE within the FOMC who were pushing these very same arguments.
He managed that by deftly turning the focus of the argument for additional QE from the Fed’s growth mandate squarely to its quantitatively measurable inflation mandate.
In making that shift, Mr. Bernanke outmaneuvered the resistance’s arguments on waiting for more time to assess growth data, and most importantly, on potential harmful inflationary/bubble side effects of QE.
He also made it extremely difficult for any incoming data to derail things between then and the next November 2-3rd FOMC meeting.
With all inflation indicators, from core CPI to PCE to forward looking expectations, below the Fed’s unofficial 1.75-2% target region and dropping, the communiqué and mandate switch successfully bulldosed the public debate beyond the question of "if" they should respond to that of "how" best to proceed with QE.
On the question of "how," internal studies by the Washington Fed Governors’ staff on how to deal with potential deflationary pressures when faced with the challenge of zero interest rates, dating from Greenspan days, have consistently pointed to the need to be more, rather than less, aggressive, on both timing and size of bond purchases, in order to be effective with QE.
This is one of the major take-aways of the many "how to avoid the Japan experience" studies conducted by the Fed.
So while for reasons of internal compromise and in order to retain flexibility the Fed will be loath to pre-commit to a, say, massive US$2 trillion "shock and awe" bond purchase plan, the Board, led by Chairman Bernanke, will also be keen on keeping the flexibility to end up with a big number if needed over time, and will lead an active debate and push back against some of the more cautious "tip toe" approaches being proposed.
We expect the compromise result of this great QE debate to be a bond purchase program that focuses on a temporary monthly "flow" purchase commitment rather than a final "stock" purchase target, but that keeps the final program target end date open to revision, with a promise to keep buying as needed.
What becomes especially significant then, and Fed officials understand this, is successful communication of the metrics they will follow to judge how much to keep pumping in, for how long, and when to stop.
We expect the Federal Reserve to settle on guidelines that point specifically to its broad inflation mandate, as well as to its growth mandate, in communicating how it will evaluate the need for future easing measures and purchases of securities.
This has been described by some as adapting some sort of a soft "Taylor Rule" metric to guide QE. That would be in contrast to some who are advocating, for example, a specific yield objective as a target for QE.
Linking bond purchases to the Fed’s Congressional mandates, especially the inflation mandate, would be significant for bond markets concerned (or worried) about how much the Fed may end up purchasing.
It would mean that while the Fed is not locking itself right from the start to a massive "shock and awe" type program that would make some of the more hawkish board members and critics uneasy, for practical purposes, tying QE to a time when the data turns could nevertheless result in bond purchases that could be substantial when all is said and done.
By highlighting the Fed’s inflation mandate along with its growth mandate in making the fiduciary case for aggressive monetary policy, Bernanke has steered the great QE debate of 2010, despite resistance from fellow FOMC members, forward, and along a path that could end up in substantially higher and more prolonged bond purchases than skeptics, and markets, may assume.
(Ed: The Fed has since announced that its portfolio will be extended through June 2011 by US$600 billion.)
* Sassan Ghahramani is President and CEO of SGH Macro Advisors, a Policy Intelligence firm for Hedge Funds and Asset Managers.