Many commentators, including myself, thought the Fed would use the 19-20 June Federal Open Market Committee (FOMC) meeting as the last politically feasible opportunity to ease US monetary policy ahead of the Presidential election. This would have involved an extension to Operation Twist, as well as further asset purchases. I alluded that the Fed could lower its economic forecasts to justify further easing. The FOMC duly obliged by lowering its central tendency growth forecast for real GDP in 2012 by 50 basis points from its April reading. Economic growth is now expected to be 1.9%-2.4%. In June 2011, the FOMC was forecasting 2012 real GDP growth to be around 3.5%.
The FOMC also revised down its growth forecasts for 2013 and 2014. Given the downward bias to forecast adjustments, it is legitimate to probe for reasons why the Fed appeared half-hearted in monetary easing by only extending Operation Twist. The Fed has behaved in an enigmatic manner during 2012, helping to keep markets off-balance.
New Economic Recovery Estimates Due in July
The underlying tone of economic data in Q2 pointed to global deceleration. Why, then, did the Fed appear half-hearted? Before committing to further asset purchases, the FOMC may have wanted a more accurate gauge of any degradation to trend growth, as opposed to being potentially duped by statistical noise. This task will be greatly helped by the impending release of the annual benchmark revisions to the National Income & Product Accounts (NIPA) on 27 July.
The benchmark revisions will provide new estimates of the recovery from the Great Recession. This may prompt revisions to the so-called “output-gap” (the best measure of economic slack) and could potentially incur ramifications for policy conduct. The next FOMC meeting commences on 31 July and policymakers will have a more comprehensive update of the dynamics that have supported the economic recovery. A downgrading to previous growth estimates would indicate a higher degree of economic slack than previously deemed, raising the chances of the Fed having to engage in further stimulus. In the absence of this information, the FOMC may have felt that an aggressive asset purchase programme announcement would have been premature and may have spooked markets.
Operation Twist Extension Imparts Some Stimulus
Under the extension to Operation Twist, the Fed will purchase an extra $267bn of long-term Treasury securities via the sale of short-dated instruments by the end of 2012. This will take the aggregate size of Operation Twist purchases by the Fed to $667bn (equivalent to 23% of its current balance sheet). Operation Twist aims to reduce long-term interest rates. More importantly, the Fed’s purchases of assets susceptible to duration risk will have a secondary impact by lowering the so-called term premium demanded by private investors. The term premium reflects the extra yield demanded by investors for holding longer-dated bonds vis-à-vis a succession of shorter-dated bonds. Lowering the term premium makes financial conditions more accommodative for certain types of borrowers, thereby imparting economic stimulus.
Further Consequences of a Lower Term Premium
There has been much analysis performed by the Fed on the macroeconomic effects of a lower term premium. Their conclusion is pretty simple: lower term premiums have historically been associated with faster economic growth in the future. Under normal circumstances, the lower term premium would call for greater monetary policy restraint, all other things being equal. These are not, however, normal times.
Long-term bond yields have two main components: 1) the average expected short-term interest rate over the maturity of the bond, 2) a term premium component. Short-term interest rates are more volatile than their long-term counterparts, implying the dominant role in determining long-term interest rates. In a liquidity trap, however, the dynamics become very different. Given the Fed has indicated short-term interest rates will be anchored at current levels until at least late-2014, the term-premium will now play an important role in determining the floor in long-term interest rates. Until that floor is reached, under the auspices of an extended Operation Twist, the returns in the US government bond market will be positive. The Fed has recently estimated that its first two tranches of quantitative easing helped to reduce 10-year Treasury bond yields by 100 basis points.
Why Did the Fed Not Engage in Further Asset Purchases?
Some commentators claim the failure to undertake further asset purchases is a tacit admission by the FOMC that additional quantitative easing will be futile. These pessimists also cite Chairman Bernanke’s periodic concerns about the problems of eventually shrinking an elevated balance sheet as evidence that quantitative easing has run its course. I take a less pessimistic stance. If job creation remains below-par, or the unemployment rate rises, the Fed will then quickly cite these as valid reasons to engage in more quantitative easing. Furthermore, Operation Twist cannot last indefinitely due to the limited supply of short-term Treasury securities left on its balance sheet.
In the meantime, the Fed is still facing two major uncertainties, namely the final endgame in the eurozone and potentially unprecedented tightening of US fiscal policy in 2013. A benign economic outlook for the Fed would be: 1) eventual resolution to the eurozone crisis without having to engage in expanded dollar liquidity swaps, 2) significant dilution to the prospective tightening of fiscal policy. If it appears that neither of these outcomes will be achieved, then further expansion of the Fed’s balance sheet appears inevitable.
US Monetary Policy Needs to Offset Fiscal Policy Mistakes
Periodically, it becomes fashionable to compare the current US predicament with post-1989 Japan. The aggressive and unconventional policy actions of the Fed in the aftermath of the failure of Lehman Brothers made the monetary policy comparison inappropriate. It is fiscal policy where the US now threatens to make policy blunders analogous to Japan. Balance sheet recessions blunt the efficacy of monetary policy in the subsequent recovery period as deleveraging proceeds. Under these circumstances it is essential that fiscal policy provides support for aggregate demand. Japan did not consistently adopt this approach by engaging in fiscal austerity in 1997 and 2001, prolonging their balance sheet recession by at least 5 years. The US committed a similar mistake in 1937. Could history repeat itself?
Fiscal tightening of 5% of GDP in 2013 will occur if changes to current law are not implemented. Not only would such contraction push the US economy into recession, but there could also be major implications for the US banking system. The Fed will be monitoring fiscal events and their impact on “animal spirits” very closely. It is this uncertainty, more so than European woes, that could force the Fed to pull the trigger with a third tranche of quantitative easing.
Fiscal Policy Tightening and the Banking System
Without the US fiscal stimulus in early-2009, the drop in bank assets would have been even more calamitous: credit extended to the public sector duly rose, partly offsetting falling private sector credit demand. While private sector credit demand has recovered from its nadir, it is unlikely that private borrowers can fill a void of 5% of GDP left by federal government. There are, therefore, clear and potentially ominous implications for future asset growth of the US banking system should the “fiscal cliff” scenario transpire.
Summary and Conclusions
The FOMC’s behaviour in 2012 has been enigmatic. It has reduced economic growth forecasts for 2012 and the following two years. While extending Operation Twist will impart some stimulus to the economy, the decision not to engage in a third tranche of quantitative easing appears somewhat baffling. The Fed may be awaiting data from the NIPA revisions to recalibrate its central tendency and “output gap” forecasts.
The Fed can only watch how events in Europe will unfold, as well as the discussions to dilute US fiscal tightening. Meanwhile, Operation Twist cannot last indefinitely. As Q3 progresses, the pattern of economic releases, both domestically and internationally, should point to the inevitable conclusion that a third tranche of quantitative easing by the Fed is on its way.
