Morgan Stanley has downgraded its forecast of further quantitative easing by the Federal Reserve to one-out-of-three chance from two out of three.
The investment bank had taken one of the more aggressive views of the likelihood of a third round of quantitative easing, which involves the Fed buying securities outside of its traditional focus on short-term Treasurys.
The revision of Morgan Stanley’s views follows Tuesday's release of the minutes from Federal Open Market Committee’s March meeting.
“The FOMC minutes make it pretty clear that any Fed decision has to be driven by incoming data not pre-emptive. Thus we’ve taken out the one in three chance of a purchase of insurance,” Morgan Stanley chief economist Vincent Reinhart said in a client video posted on the firm’s website.
Reinhart, who said he wrote Fed minutes while he worked at the Fed, pointed out that the Fed had marked up its estimate of aggregate demand while it marked down its estimate of aggregate supply.
“That means they think there’s less slack in the economy than they once thought and, therefore, more risk of inflation rising,” Reinhart said.
If the Fed is wary of inflation, it is less likely to initiate further quantitative easing.
Morgan Stanley still assigns a one in three chance of further easing in the first half of this year, however, because it believes there is a good chance the economy could noticeably slow.
“With our economic forecast, though, we still believe it is possible that signs of slowing growth will accumulate to the point that the Fed provides accommodation,” Reinhart said.
Reinhart warned that the Fed could have too high of a hurdle for further action. If the Fed is over-confident about economic prospects or wary of easing in the months running up to the presidential election, the Fed could fail to react in time to prevent a significant slowdown, Reinhart explained.
On the other hand, the lack of Fed action could be a sign that the economy has “broken out above trend in a sustainable manner.”
Reinhart warned that the Fed’s communications may be confusing in the coming months. Investors should be wary of misreading Fed talk about inflation and economic slack that is intended to communicate its message about Fed Funds rates as indicating that more quantitative easing is coming.
Fed funds futures currently indicate a rise in rates in early 2014, while the Fed indicated at its January meeting that they believe rates will stay low through late 2014. That indicates a “failure to communicate,” according to Reinhart.
“They’re going to have to protest that difference, probably by explaining how much slack remains and how well inflation is behaved. That’s protesting rates, not signallying QE,” Reinhart said.