FYI | Aug 25 2011
– Talk is that the Fed will announce QE3 at Jackson Hole 2011
– The Fed did not announce QE2 at Jackson Hole 2010
– No formal policy announcement is expected on Friday
By Greg Peel
It was at this time last year at the Fed's Jackson Hole retreat, we have oft been reminded recently, that Ben Bernanke announced QE2. Thereafter, the stock market rallied to new post-GFC highs. The circumstances are so similar this year that a QE3 announcement must be imminent on Friday.
Encouraging stuff, if only it were true.
Contrary to popular belief, Ben Bernanke did not announce QE2 at Jackson Hole last year. Indeed, as Commonwealth Bank's forex strategists point out, the Fed only ever makes policy change announcements in statements accompanying scheduled policy meetings, and never in unrelated speeches. This was very much the case at Jackson Hole in 2010, where Bernanke merely outlined a range of potential policy measures the Fed may pursue were the US economic outlook to deteriorate, of which there were three "and/or" options.
One was to put a stated time line on its hithertofore vague “exceptionally low rates for an extended period” commitment. Another was to expand the Fed balance sheet by buying more longer term US Treasuries. And the third was to reduce the deposit rate paid to US banks parking funds with the Fed for safety rather than lending them into the US economy.
The first option has been implemented, but only at the Fed's policy meeting earlier this month (cash rate fixed at zero for two years, albeit “fixed” is not definitive). The third option has never been implemented and thus remains an option. The second option was implemented, but not until the Fed's November 2010 policy meeting. The second option is colloquially known as QE2.
In July 2010, Wall Street hit its low for the year as double-dip fears abounded and Greek debt contagion spread to other eurozone members. This was enough for the market to anticipate QE2, and hence there was a rally into August but that faded once more as no action was forthcoming from the central bank. Wall Street was looking for “a sign” from Bernanke at Jackson Hole but realistically there was no commitment. Wall Street rallied on the day on the back of a positive GDP revision but fell again the following Monday.
Subsequent fresh economic was nevertheless weak, and the case for QE2 appeared in place. At a point which affected a head-and-shoulders bottom on the chart, Wall Street started its “QE2” rally which lasted all the way to April this year. The actual QE2 announcement in November had already been taken for granted.
CBA's forex strategists believe markets are building themselves up for disappointment on Friday, for two reasons. One is that were the Fed to be planning QE3, it would not be formally announced at Jackson Hole. The second is that the Fed is not planning QE3.
CBA is far from alone in assuming that this time around the Fed is not looking to expand its balance sheet further, as was the case for the initial post-Lehman QE (March 2009) and QE2. In 2010 there was a clear risk of US deflation, while in 2011 US inflation has been ticking higher. Buying Treasuries using printed money is clearly and deliberately inflationary. CBA, and most others, suspect the Fed will indeed buy longer-dated Treasuries but do so by using the proceeds of maturing shorter-dated holdings or by selling shorter-dated holdings. This way the Fed's balance sheet does not expand and inflation risks are “sterilised”.
Such a policy is still a form of quantitative easing in the sense that it is stimulatory monetary policy, but it's not as nakedly stimulatory as unsterilised QE. One presumes that while this is what the “smarter money” on Wall Street is expecting, those assuming naked QE3 may well be in for disappointment.
Indeed, in analysing and comparing movements in the US yield curve this year and last, it's exactly what the US bond market is factoring in, notes CBA. The stock market on the other hand, at least by virtue of a 440 point Dow rally over the past two sessions, seems to be assuming something more exciting.
And of course as noted, Bernanke will not be formally announcing anything at Jackson Hole. CBA expects that as was the case last time, Bernanke will merely outline the Fed's view of the state of the US economy, review the policy responses made to date and outline a suite of possible responses still available if, and only if, they are needed. One of these could be to put a specific time frame on how long the Fed will maintain its balance sheet at the current size (just as it has put a time frame on zero interest rates) and another might be sterilised QE3.
We should recall, nevertheless, that the Fed is already undertaking a form of sterilised QE post QE2, being that which many previously dubbed QE2.5. Since the Fed's QE2 bond purchasing program expired in June, the central bank has not let its balance sheet run down as earlier holdings mature but has been reinvesting those funds, and all interest paid, into longer dates.
In other words, all the Fed might eventually announce to “save” the US economy this time as a form of QE3 may not be very much different to what's already happening.
Another point is that this year the Fed has been surprised at just how weak US economic growth has been, but has also declared an underestimation of the negative flow-through effect from the Japanese tsunami. Recent Japanese data have shown the rebound is underway, which suggests a positive flow-through is in effect this time. Last night's July durable goods orders data in the US surprised to the upside — indeed doubled expectations. The Fannie/Freddie house price index rose for the third month in a row. Not all signs are for a dangerously deteriorating US economy.
