Prepare to Be Surprised by QE3
I think there's a lot of misunderstanding in the markets about how Fed chairman Ben Bernanke views Fed strategy.
A lot of people seem to think of Bernanke as very much confined to using tools he's already employed. This is one reason we keep hearing about the Fed being "out of bullets" or "shooting blanks." People just keep making the mistake of thinking that there aren't more creative things the Fed can do to address economic problems.
So everyone expects that the Fed will, sooner or later, have to announce a new round of quantitative easing. And this round will look pretty much like the last round:
Record-low yields on U.S. Treasuries show traders expect Federal Reserve Chairman Ben S. Bernanke to signal as soon as this week that the central bank will begin a third round of asset purchases to boost the economy, a scenario the world’s biggest bond dealers said is unlikely.
Barclays Plc said 10-year yields indicate traders have priced in $500 billion to $600 billion of Treasury purchases by the Fed. Citigroup Inc. said current rates can only be justified by more central bank bond buying or assuming the economy will shrink by 2 percent.
“The market is pricing in another round of large-scale asset purchases, looking for confirmation possibly as early as the Jackson Hole symposium” in Wyoming this week, Anshul Pradhan, a fixed-income research analyst at Barclays in New York, said in an interview last week. “The probability of that is low. If the Chairman does disappoint, then there should be a reversal in the outperformance of 10-year notes.”
But if you look at Bernanke's academic work, it is very clear that he believes effective monetary policy when rates are up against the zero bound needs to surprise markets. It must catch markets unawares, go beyond expectations.
This means that if the Fed does return to buying unconventional assets, we should look for it to buy something different from another few hundred billion Treasuries.
"At this point, I think it’s abundantly clear that QE2 didn’t do much for the US economy. You almost have to have been asleep over the last year to conclude that more QE is now going to save the day. As I said before it even started, QE2 was a monetary non-event. QE3 will almost certainly be more of the same unless Bernanke substantially alters the form in which it is implemented," Cullen Roche writes over at Pragmatic Capitalism.
I think Roche is half-right there when he says that QE2 didn't work so we're not likely to see a QE3 that is more of the same. The next stage of easing is not likely to be more of what's been done before. It will probably involve buying a different mix of assets and be set to involve something more than what bond prices appear to have already priced in. In Roche's words, I think Bernanke "substantially alters the form" of easing.
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