Will the Fiscal Cliff Force Further Quantitative Easing?
Now that the US Presidential election is over, financial markets are focussing on the prospect of a full-blown fiscal cliff scenario engulfing the economy. Observers agree that such an outcome would be disastrous: the economy would fall into recession, producing a renewed rise in unemployment. It would make the post-Great Recession economic recovery exceptionally short by post-war standards. The Fed will clearly attempt to invoke offsetting monetary accommodation if it believes that fiscal policy risked pushing the economy into recession.
The Fed has been forced to walk a political tightrope since the financial crisis. Its interventions with respect to Bear Stearns and American International Group did not please everyone on Capitol Hill. The uneasy relationship between the Fed and Capitol Hill was sharpened when the Fed invoked quantitative easing: the Fed was accused by some politicians as helping to fund profligate fiscal policy. This is an unfair accusation: central bank asset purchases are required to both infuse liquidity and lower interest rates. It is fair to assert, however, that the invocation of quantitative easing helped to show that monetary and fiscal policies can stabilise the financial system and the real economy. The arrival of a full-blown fiscal cliff would push the Fed into further asset purchases, and Chairman Bernanke would be prepared to face any political flak for this decision from Republicans.
The Impact of the Fiscal Cliff on the Real Economy
As I outlined last week, the onset of a full-blown fiscal cliff would have a significant impact on economic activity in 2013. The Congressional Budget Office (CBO) estimates that such a scenario would depress real GDP by 2.9% in 2013 and reduce employment by 3.4 million jobs. This is clearly an undesirable outcome for the Fed and Congress. Both political parties agree that measures to ensure long-term fiscal sustainability is required, but depressing real GDP by 2.9% in 2013 is a too big a price to pay for achieving this goal. Small wonder why financial markets are worried.
The supreme irony is that the sticking point to any compromise deal being reached, namely the extension of the Bush tax cuts, would have virtually zero impact on the economy in 2013 if they are allowed to expire, according to the CBO. A compromise will undoubtedly be reached, but not without major political wrangling. Against this backdrop, both the private sector and the Fed will be forced guess the structure of the compromise. This backdrop will only fuel uncertainty, producing a difficult environment for risky assets.
The Future Path of US Monetary Policy
The Fed has stuck to its guns in terms of the framework it deploys to determine its policy stance. Under Chairman Bernanke, the Fed has deployed a so-called “forecast-based” policy framework, where the internal economic forecasts of Fed staff dictate the underlying policy stance. The degree of transparency attached to policy formulation at the Fed has increased massively over the past 25-years. It is possible, therefore, to get a reasonable snapshot of current lines of thinking within the Federal Open Market Committee (FOMC). The minutes to the 23 October FOMC meeting provide some important clues about the prospective path of monetary policy, which is already deep into uncharted territory.
Expectations of underlying economic growth within the FOMC remain subdued due to the nature of current dynamics. Weakness in capital spending is offsetting improvements in consumer spending and housing activity. Furthermore, the FOMC recognised the potential for downside risks to its baseline outlook due to weak foreign economic activity. This fear was justified by the recent announcements that GDP in Japan and the Eurozone contracted in Q3. Another source of downside risk to its baseline economic forecast is further financial shocks. The fiscal cliff is considered by the FOMC as a form of financial shock. The bias of policy is towards further easing. How can the Fed counter a shock with interest rates already close to zero?
There is no clear consensus within the FOMC about how to respond to renewed economic weakness. Zero interest rate guidance already extends into 2015. There appears to be a growing sympathy towards issuing threshold guidelines for inflation and the unemployment rate (or even nominal GDP) before changing interest guidance. The ultimate goal of the FOMC is to persuade the private sector to change its current cautious behaviour. Announcing economic target thresholds may help the Fed convince the private sector that it is committed to restoring the economy to a state that satisfies its dual mandate. Ultimately, the Fed may need to invoke further expansion of its asset purchase programme to change private sector behaviour.
Adopting Quantitative Thresholds Force New Fed Operating Procedures
Chairman Bernanke has asked Fed staff to undertake further research on the policy practicalities of embracing threshold guidelines. There is little doubt, however, that the degree of Fed activism in financial markets would increase. The Fed’s involvement in financial markets has historically been restricted to open-market operations and periodic bouts of intervention in the foreign exchange markets. Under quantitative easing, the Fed has become a big player in the US Treasury and mortgage backed securities (MBS) markets. Some FOMC members are concerned that these markets have been distorted by the Fed’s significant holdings of these assets. Does this mean that unconventional purchases will be ruled off-limits in 2013? The answer: no.
The current FOMC composition appears to indicate that 3 members are against further asset purchases in any shape or form. Should the economy face increased recession risks in 2013, then these members would clearly hold untenable policy views. Further asset purchases would be back on the agenda. What is the most important change in the Fed’s operating procedure in 2103? Assuming the onset of a fiscal cliff scenario in 2013, the Fed would quickly institute policy thresholds for inflation and the unemployment rate. There could potentially be a threshold for nominal GDP. Changes in policy conduct will also be invoked with the announcement of additional asset purchases to underpin the new policy thresholds. The timing of these announcements will be determined by the progress made in averting the potential fiscal cliff.
Politics Could Determine Monetary Policy in 2013
I wrote last week that the re-election of President Obama significantly reduced the risk of political pressure being exerted on the Fed: the Republicans are no fans of quantitative easing. President Obama has always respected the independence of the Fed. Politics could, however, loom large if the Fed is forced to engage in further monetary accommodation due to a return to brinkmanship in Congress. In terms of possible political deadlines, the Fed will focus on the amount of progress achieved during the lame duck session of Congress. Failure to reach a full agreement by year-end could mean that negotiations are deferred until President Obama’s inauguration and the arrival of the new Congress on 21 January.
The first FOMC meeting in 2013 is 29-30 January. Thereafter, the following meeting is not scheduled until 19-20 March, a gap of nearly 2 months. If there is no deal reached to avert the fiscal cliff, then the FOMC may feel compelled to announce its commitment to additional asset purchases and policy thresholds at the 29-30 January FOMC meeting. Treasury securities will form part these purchases.
Financial markets have discounted a 1% tightening of fiscal policy in 2013. This outcome would be consistent with continued sluggish economic growth. The key unknown is whether the resultant growth is able to support corporate profit expectations for 2013. Until we learn of the extent of fiscal tightening and the possible response from the Fed, risky asset markets will continue to exhibit nervousness. Rightly so!
Summary and Conclusions
Financial markets are concerned about the prospect of a fiscal cliff unfolding in the US, resulting in a recession in 2013. The Fed would invoke offsetting monetary accommodation through additional asset purchases under this scenario, irrespective of potential political opposition.
The sticking point to any fiscal policy compromise is the Bush-era tax cuts. Their expiration would ironically have virtually zero economic impact in 2013.
The FOMC expects the economy to remain subdued in 2013, but risks are massively biased towards the downside. While there is no consensus within the FOMC about the appropriate policy response to further economic weakness, there appears to growing appeal towards adopting policy thresholds for inflation and the unemployment rate.
Adopting policy thresholds will require changes to the Fed’s asset purchase programme. These changes can be instituted quickly in early-2013 if needed, particularly if it appears likely that the fiscal cliff cannot be avoided.
Political developments will play a big part in terms of monetary policy conduct in 2013. Markets are discounting fiscal tightening of 1% of GDP. If there is insufficient progress in avoiding the fiscal cliff by 21 January, then the Fed will feel compelled to announce additional asset purchases at the 29-30 January FOMC meeting.
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