TWA: Not Perfect, But Close

Shawshank, VA 8/8/2011 (PennyPayDay) -- It is unlikely that the Fed will decide on Tuesday that now is the perfect time to panic. I think they could indicate that they have moved a few steps closer to making another Hail Mary pass, but are not yet ready to launch it.

In many respects this year is unfolding in a manner that is eerily similar to a year ago. The Fed wrapped up QE1 at the end of March 2010. Within a few weeks the stock market topped out and proceeded to decline; it was down seventeen percent by early June. In the post QE period the labor market was not showing much progress and the overall economy was laboring to move forward. And European debt was a problem without an obvious, or at least without a painless, solution.

The scorecard for this year: stocks down considerably since the end of QE2, labor market and other economic indicators are weakening and the situation in Europe is just as convoluted, in some respects more so, as it was a year ago; check, check and check.

At the August 2010 FOMC meeting the Fed took a baby step toward QE2 when they agreed to reinvest their maturing securities into Treasuries so as not allow policy to unintentionally tighten. A few weeks later at the Fed Fest at Jackson Hole Chairman Bernanke strongly suggested that they would pursue additional accommodation, which they acted upon at their November policy meeting. But the reason they acted so quickly and aggressively last year was because the core measures of inflation were allowing them to. Despite record stimulus and rock bottom rates the PCE Core peaked in the month QE1 ended and then headed back down to the cycle low. Deflation became a primary concern for the Fed and Bernanke saw no alternative but to act.

The path of inflation is the key difference between this year and last. The PCE Core rate fell to a fifty year low of 0.9% at the end of last year, but has increased throughout 2011, rather than decline as it did in the aftermath of QE1. Additionally, there are many members of the policy committee who have set the bar very high for making another attempt at turning the economic tide with another round of creative monetary policy. It is hard to imagine a majority agreeing to a new venture in the first meeting since the previous strategy wound up.

But, on the other hand, a lot has changed since the FOMC last gathered in June. Growth has been revised significantly lower; the GDP for the first half of the year is now said to be 0.8%; I’d say that’s not much bang for the QE buck. While the Fed may still think this is a temporary pause and not the beginning of a reversal of trend, that argument is getting harder to believe when economic observers such as Martin Feldstein rate the odds of another recession at fifty/fifty.

Although Bernanke insists that it is the size of the Fed’s balance sheet and not the process of buying the assets that is the most important factor for the economy, that too is a tougher sell given the action in the stock market and economy in the periods that follow the final bit of Fed buying last year and this. Even though the PCE Core has steadily increased since the end of last year, it is, at 1.3%, below the level it was at when Bernanke laid the groundwork for QE2 in Wyoming in August 2010.

And, because of the collapse in crude oil and many other commodities since the springtime peak, the argument for further gains for inflation is dubious and the possibility of a move back down not so unlikely as the Fed thought a couple of months ago. The unemployment rate may have fallen by a tenth in July, but a Bernanke favorite indicator, the employed to population ratio, also known as the employment rate, fell to 58.1 last month, a new low for the cycle. I didn’t even mention that when the FOMC last met the US was rated AAA by all three rating agencies, but that is no longer true and the ramifications of the move by S&P may not be positive for the economy, huh?

The FOMC may not be ready to take additional action this week, but they may say they are not far from taking such a decision. In his Humphrey/Hawkins testimony to Congress in mid July Chairman Bernanke suggested a few thing he might want to try should things not go well for the economy. “On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support.

Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs.

However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.”

He went on to explain the other side of the coin, “the economy could evolve in a way that would warrant a move toward less-accommodative policy…” Never mind, no reason to think about that possibility any time soon.

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