There is a serious danger that the Federal Reserve’s strategy of attempting to jaw-jaw the economy into better shape over the last few months has set it up for a massive failure. To avoid failure, some are wondering if the Fed will go for a Japan style 'shock and awe' asset buying program next week.
Fed officials are well aware that they are caught in an expectation trap. The widespread view that next week’s Fed announcement could be a ‘sell on the news’ event must have Fed officials worried. If markets fail to react—or, worse, react negatively—to the Fed formally announcing a revived qualitative easing program, the Fed’s credibility as a formidable force in the economy could be damaged.
And that damage is something the Fed wants very badly to avoid.
The consensus in the market is that the Fed will launch QE2 on November 3rd. Nearly everyone thinks that because this consensus expectation is so well-established, the next round of qualitative easing has been fully priced into the markets. This means that the Fed will gain little by announcing a program that merely meets market expectations while facing serious risks if it disappoints the market by, say, announcing anything short of a half trillion program to purchase Treasuries.
The Fed seems so worried about the expectations on QE2 that even the inflation doves seem to be trying to reset expectations about the effectiveness of Fed actions. Yesterday, we heard from easy-money devotee William Dudleythat the Fed could only provide “essential support” to a recovery but could not “wave a magic wand” to set the economy on track. In politics they call this “lowering expectations.”
Interestingly, a report out of Bank of America Merrill Lynch today argues that not only is there a consensus that the Fed will launch QE2—there is a consensus that QE2 will fail to make a serious positive impact on the U.S. economy. (Yesterday, Dominique Dwor-Frecault, Royal Bank of Scotland’s macro strategist, gave one version of this position on World Wide Exchange, arguing that QE2 wouldn’t produce economic growth in the US but would inflate assets in emerging markets.)
Merrill thinks this means the Fed will likely up the volume on it’s attempt to jaw-jaw the economy into higher gear.
From Merrill’s report:
Given that the Fed’s failure is essentially now a consensus view (based on, for example, the changes in Blue-Chip economic forecasts of GDP, inflation, and unemployment from August to October, Chart of the day), and given that failure is not an acceptable outcome, the Fed, in our opinion, is likely to introduce powerful new language and strategies that could ultimately cause the market to reprice the expected future path of Fed funds
The Fed knows that failure can occur simply because failure is expected, rather than any flaws in the plan. As a result, we think the Fed may purposely respond in a way that the market does not expect, with the result being a continuation of the trend in the major market variables listed above: curve, dollar, rate, commodities, and breakevens.
The Fed’s strategy change was hinted at in the last FOMC minutes (from the September meeting) in which the committee discussed a number of possible ways to affect short-term inflation expectations, including giving more detailed information about desired rates of inflation, introducing price or inflation targets or even a GDP target. Bernanke also said recently that one option the Fed has is to explicitly state that the committee expects to keep target rates low for longer than the market anticipates.
Although it is not possible to forecast the Fed’s curve ball, we think it is much more likely that the big surprises come in the form of communication changes rather than in asset purchase surprises and that these communication changes will signal a much more aggressive approach to easing.
Which is to say, Merrill does not think the Fed will go the way of the Japanese central bank, which recently announced that it was willing to purchase just about anything under the sun.
But isn’t there a risk that the Fed exposes itself as inadequate if it attempts more ‘jaw jaw’ without any real ‘shock and awe?’ We know that Fed governors are concerned that the perception of a Fed failure could be a pull back the curtain moment—where the great Oz of Emerald City is revealed to be a little old guy impotent to set things right. If ‘jaw jaw’ fails, won’t the Fed have proved its impotence?
Merrill’s analysts argue that the risk of perceived impotence is even greater if the Fed undertakes a massive asset purchase and it fails.
While an announcement to purchase US$2tn in 12 months would certainly be a major surprise, and would have a large initial impact on rates, dollar, curve and commodities, it would also greatly increase the chance that the market pronounces a Fed failure within a short amount of time. If the unemployment rate remained high for a few months following a shocking purchase announcement, for example, the market could quickly form an opinion that asset purchases, no matter how large, will be ineffective. Even if the Fed ties asset purchases to changes in economic indicators, the market could easily move to a level of irreversible doubt and skepticism, especially in light of the similarities that would inevitably be drawn between the ineffective Fed and past BoJ QE programs.
In short, the Fed may choose ‘jaw jaw’ over ‘shock and awe’ in order to maintain the perception that it still has ‘dry powder.’
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