The behaviour of risky assets during Q2 has given central banks much to think about. Economic data released during the quarter has been broadly consistent with deceleration in global economic growth. US economic growth during Q2 was probably running at around +2%. The politically-sensitive US unemployment rate has failed to improve significantly in 2012, while gains in non-farm payrolls have clearly moderated from impressive weather-assisted increases during Q1. A continuation of strong payroll gains into Q2 would have ruled out any chances of further quantitative easing by the Fed. The economic environment over which the Fed currently presides strongly suggests that we will see another tranche of quantitative easing, potentially as early as this week.
Domestic Reasons for Further Quantitative Easing
The Fed is legally independent, but its actions are held accountable to Congress. There are 3 policy mandates: 1) maximum sustainable employment, 2) price stability, and 3) moderate long-term interest rates. The current 8.2% level of US unemployment is above the so-called “natural” rate. The Fed would ideally like to see the headline unemployment rate drop further. Assuming the Fed believes that elevated unemployment is largely cyclical, reflecting weakness in aggregate demand, then further quantitative easing can be justified with the view to supporting labour demand.
The effects of changes in monetary policy are invariably felt after a lag. The generally accepted lag is 12-18 months. Therefore, it is in the interests of the Fed to anticipate changes in economic conditions. The Fed has formally embraced “forecast-based” policy under Chairman Bernanke. A further round of quantitative easing could be justified by lower economic growth forecasts by Fed staff members. There is an excellent chance that the Fed will lower its so-called “central tendency” forecasts at the next FOMC meeting on June 19-20.
The minutes to the next FOMC meeting, which would confirm any downgrading to the Fed’s economic forecasts, will be released on July 11. From a political standpoint, the Fed would like to sit on the side during a Presidential election year to avoid possible accusations of political bias. This option in 2012 may not be available. Notwithstanding the real possibility of a decelerating global economy, the chances of a severe tightening of US fiscal policy also loom large.
US Monetary Policy Needs to Offset Tighter Fiscal Policy
The looming expiration, at year-end, of the Bush-era tax cuts and emergency unemployment insurance potentially produces a very significant tightening of US fiscal policy (5% of GDP). In fact, the prospective tightening is unprecedented. The last occasion fiscal policy was tightened by anything approaching this order of magnitude was in 1969. The economy was plunged into recession by a simultaneous tightening of both fiscal and monetary policies. The Fed will be keen to avoid a repeat of the 1969 episode.
US Private Sector Could React Badly to Fiscal Uncertainty
The US private sector delayed risk-taking decisions during last summer’s political standoff in raising the debt ceiling. It is widely discounted that any serious discussions aimed at reducing fiscal tightening will be delayed by the Presidential election campaign. This backdrop implies that the lame-duck session of Congress after the election will have just 6 weeks to dilute prospective fiscal policy tightening. Furthermore, the US will, once again, be nearing its debt ceiling limit after the election, enhancing the chances of another damaging political standoff.
Given the partisan nature of pursuing policy agendas, the Fed has probably already discounted tighter fiscal policy in 2013. The real unknown is how the private sector, faced with uncertainty about the future tax regime, will change its behaviour. Will hiring and investment plans be shelved once again? Against this backdrop, the Fed could easily justify further easing as an insurance policy against weaker growth in 2013.
External Reasons for Further Quantitative Easing
The US dollar enjoys special “safe-haven” status during times of uncertainty and risk-aversion. It is hardly surprising that the US currency has benefitted during the eurozone crisis. We are reaching judgment day about the tenability of the eurozone’s current structure. Markets have recently been focussing on the financial implications of Greece exiting the single currency. These concerns may have been temporarily dispelled by the outcome of yesterday’s general election in Greece. There is still, however, a significant chance that Greek membership of the euro will again come under intense market scrutiny.
Much depends on the nature of any potential exit by Greece. A disorderly exit could trigger another period of elevated stress in financial markets. Without doubt, there would be a huge scramble for US dollars, Swiss francs and, possibly, Japanese yen. The Fed would, without question, boost its dollar swap liquidity lines with other central banks. This would de facto boost the size of the Fed’s balance sheet, constituting another form of quantitative easing.
Foreign Considerations Extend to the BRIC’s
The global recovery from the Great Recession has been based on different growth paths between the developed and emerging economies. High levels of private debt in the developed world have meant that deleveraging has been a significant headwind to returning to “normal” rates of growth. Meanwhile, emerging economies, less encumbered with high leverage, have been the engine of global growth. It now appears, however, that Brazil, Russia, India and China (BRIC) are experiencing slower-than-expected growth. This has forced central banks in the BRIC’s to either ease or re-think policy stances.
There has effectively been convergence in the global economy in 2012 via slower growth in the BRIC’s. The US dollar against emerging market currencies has appreciated 5% in nominal terms and 3% in real terms since February. This constitutes an effective tightening, albeit modest, of US monetary conditions with implications for economic growth. Countries with appreciating currencies will import deflation and export growth, while those countries with depreciating currencies will import growth and export deflation. The Fed would be unwilling to witness significant amounts of deflation being imported into the US, because real debt burdens would rise and subsequently restrict US economic growth.
The Fed has, therefore, two additional reasons to engage in further quantitative easing, based on foreign considerations. Firstly, slower growth in the BRIC’s could threaten to de-rail the current global economic expansion if there is not more robust US growth. Finally, appreciation of the US dollar versus emerging economies’ currencies represents a de facto tightening of US monetary conditions during a time of US private sector deleveraging. Fed Chairman Bernanke could easily argue that easier US monetary policy is required to match easier conditions in emerging markets.
Summary and Conclusions
Slowing global economic activity has become increasingly evident in 2012 Q2. Easier monetary policy is the only effective offset. The US faces a very significant tightening of fiscal policy in 2013. The private sector cannot fill this vacuum. The risk is that any moves to ease the degree of fiscal tightening will be embedded with discussions about how to raise the debt ceiling. This could significantly impact private sector confidence in an adverse manner.
The Fed has enough reasons, both foreign and domestic, to justify further quantitative easing as an insurance policy against economic weakness. The easing could be through further asset purchases or expanded dollar liquidity swaps with other central banks. Having to engage in any policy easing much closer to the election would be politically contentious and economically carry greater risks.
