FYI | Oct 04 2010
By Greg Peel
While the Reserve Bank of Australia and other central banks around the world set a simple monthly timetable for monetary policy meetings (the RBA has a break in January, however), this is not the case with the US Federal Reserve. The Fed works on a more convoluted timetable which includes months with no FOMC meeting, and October is one of those.
So unless the Fed decides to act outside of a meeting, Wall Street is facing a frustrating month ahead. Stock markets are now being totally dominated by speculation that the Fed will implement a second round of quantitative easing – QE2 – which will include any or all of specifying its timing on the “extended period” of “exceptionally low rates” (meaning the current funds rate range of 0-0.25%), dropping the interest rate paid on bank deposits at the Fed from 0.25% to zero to discourage cash hoarding by banks, and, most importantly, recommencing the purchase of US Treasury bonds with freshly printed money.
Previously, the Fed had indicated it stood ready to implement QE2 were the US economy to “deteriorate appreciably”. Given recent data have been “less bad” than earlier data, one might assume the likelihood of QE2 has been reducing, but then the Fed came in and upped the stakes. The Fed has now suggested QE2 is ready to be used to fight deflation and promote inflation at the Fed's comfort rate, as is the central bank's mandate. No longer is an appreciably deteriorating economy a necessity.
What this has meant is largely a “win-win” situation for Wall Street over the past month, and as such it's of little surprise stock markets had their best September since 1939. If economic and inflation data are positive, or at least “less bad”, then that's good for stock values. If the data are negative, then that implies QE2, which is good for stock values given the monetary stimulus QE provides.
Take Friday night's US economic data releases as an example. The manufacturing PMI slipped in growth rate from 53.7 in August to 52.5 in September. This is not appreciable deterioration as it is still an expansionary result, but it is nevertheless further evidence the US economic recovery is stalling. August personal income and expenditure data were positive, in that incomes rose by 0.5% and spending by 0.4% which were both better than expected results. But annual core inflation on consumer spending is running at only 1.4% and the Fed's comfort range is 1.5-2.0%.
So one might argue right there that the Fed needs to do something to promote inflation even if actual deflation is not yet apparent. While Wall Street weighs up the data on a “will they, won't they” basis the other problem is there is clear dissent within the Fed ranks. This alone makes QE2 a toss up.
The Federal Open Market Committee (FOMC) is made up of twelve voting members including chairman Ben Bernanke, members of the Fed board, and five regional Fed presidents of which New York is a permanent member (it controls the funds) while the others rotate annually. Policy changes can only be enacted on a majority vote of FOMC members.
Ben Bernanke is well known as a big fan of the printing press, almost to the point of arrogant American jingoism. To date he has received support from all FOMC members bar one in at least considering QE2. Kansas City Fed president Thomas Hoenig is not only against QE2, he is in total disagreement with the Fed's “exceptionally low interest rates for an extended period” policy. Hoenig is worried this “cheap money” policy is no different to the “cheap money” policy instigated by Bernanke's predecessor Alan Greenspan in the wake of 9/11 and the tech-wreck – a policy which Greenspan now admits was wrong as it fuelled what was to become the GFC. Hoenig simply sees another asset bubble (property, stocks, bonds) emerging from stimulated monetary policy, and thus by implication a GFC2 down the track.
Hoenig might be alone within the FOMC, but he is not alone amongst the wider collection of regional Fed presidents (of which there are 12). Last week the Philadelphia Fed president made a speech in which he argued against QE2, while the Minneapolis president also made a speech and argued QE2 was pointless because it wouldn't work.
The Fed instigated QE1 in March 2009 by announcing US$1.7 trillion of intended Treasury bond purchases. Unsurprisingly, the stock market then began to rally. This was seen as a “shock and awe” tactic by the Fed when Wall Street had reached its lowest ebb post-Lehman. Ultimately, the US economy went on to post 5% GDP growth in the December quarter.
On that basis, one might argue QE does work. But the question is: has QE1 proven ultimately successful? US GDP growth has now fallen back under 2%, the stock market is little higher than where it was at the beginning of 2010 and near 10% unemployment persists, with little sign of any meaningful reduction.
If one equates QE with providing pure oxygen to a patient with breathing difficulties, then one can argue the oxygen is keeping the patient alive but not curing the breathing difficulties. The Fed has been maintaining the same level of oxygen since March 2009 (now swapping maturing mortgage securities on its balance sheet for new Treasury bond purchases) but the patient has been fading after an initial response. Is more oxygen the answer? Or perhaps a more extensive operation is needed which actually gets to the heart (or lungs) of the problem?
Complicating the issue is the upcoming Congressional elections in November. The Fed has emphatically flagged that if it is going to further stimulate, it expects the government to follow suit with fresh fiscal stimulus measures. So far the Obama Administration has introduced some small business measures at the margin, but America is awaiting news on all-important tax policy. Obama has flagged that he will extend the Bush income tax cuts for all bar the top 2% of earners, but early in his presidency he had also flagged an intended increase to capital gains tax. In short, net tax policy is still an unknown, and an unknown that is helping to keep volumes very low on Wall Street.
Is Obama preparing to make his big policy announcements shortly, ahead of the mid-terms? Clearly the Fed would like to know.
There is also the matter of Obama's new health bill, which comes at a cost to the taxpayer and to businesses providing health cover, and the new financial regulations bill, which is still incomplete and proving insufficiently specific for investment banks to be entirely sure of its implications. Either way, it reduces investment bank leverage, and thus earnings power. Financial sector analysts are now predicting another big round of Wall Street lay-offs as regulatory constraint and a dead-quiet market take their toll.
The expectation is that the Republican Party will “take back the House” in November, implying the Democrats will no longer have a majority in either the Senate or the Reps. Not only does this mean difficulty for Obama in passing any new laws which do not sit well with the GOP anti-socialists, but current legislation can also be reviewed.
All of which adds to the uncertainty, not just for Wall Street but for the Fed itself.
In the meantime, on Friday night New York Fed president and FOMC voting member William Dudley called the current levels of US unemployment and inflation “unacceptable”, adding more grist to the QE2 mill. Last week the Boston president and voting member also reinforced his support.
So Wall Street is just going to have to wait, it would seem, to find out whether QE2 is on or off. Every economic data release between now and the November FOMC meeting will add more fuel to the argument one way or another. Stock markets have already built in a solid “QE2 premium”, so it's hard to see significant upside in the interim.
However, in another couple of weeks the US third quarter earnings reporting season will begin. Obviously at the end of the day, corporate earnings are what drives share values. But once again, Wall Street will be stuck on the notion that while good results are good, bad results might hurry up the Fed.
On that basis it would be hard to predict downside. Yet Wall Street is starting to look a bit frustrated, the longer QE2 is an unknown. After a 9% rally in September, can stocks hold on all through October? Or might frustration lead to impatience, and impatience to selling?
That's the October we can look forward to.
