QE vigilantes 1, The Fed 0

Surprise! Most, including myself, had expected the Fed to announce a tapering at today's meeting. My view - likely in the $10 billion range.

Instead, there was no change in policy.

My thoughts:

1. The Fed doesn't have much confidence in its economic outlook

2. The Fed is concerned about the back-up in interest rates and the possible effect on housing

3. There is some concern about fiscal restraint and the budget battles that loom.

Much of this comes directly from the Fed's statement.

Just to illustrate: 

“The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market (italics,underlined my emphasis and a new addition to the September statement vs the July statement).

"...but mortgage rates have risen further and fiscal policy is restraining economic growth."

Stocks surged, with the Dow and the S&P hitting a new record, but the focus will shift to the upcoming budget battles. Plus, will investors get that uneasy feeling since the Fed isn't seeing the kind of economic activity they had envisioned?

For now, the QE vigilantes that drove rates skyward seem to have forced the Fed to blink, and Bernanke is no longer so focused on a jobless rate that had given him the green light to taper.

Damage control, feral hogs, and the QE vigilantes

It's just been a few days since Bernanke told us that QE is on the chopping block if the economic data play out like the Fed expects. Market reaction, however, has been less than kind.

So we're seeing some damage control today by a couple of more hawkish Fed members - non-voting FOMC members but nonetheless influential Fed members.

First, Minneapolis Fed head Kocherlakota felt compelled to issued a statement saying it may be appropriate to keep the fed funds rate at an extraordinarily low level at least until the unemployment rate falls below 5.5%. Recall that Bernanke's threshold is 6.5%.

Then we have the always colorful Dallas Fed President Richard Fisher who told the Financial Times, "...big money does organize itself somewhat like feral hogs. If they detect a weakness or a bad scent, they’ll go after it.”

Though he has never been a fan of QE, he repeated he doesn't want to go from" wild turkey to cold turkey overnight."

This brings us to a new group of bond traders on the Street - the QE vigilantes.

Most of have heard of the bond vigilantes.Wikipedia offers a good definition - When investors perceive that inflation risk or credit risk is rising they demand higher yields to compensate for the added risk. That in turn helps keep inflation and government spending in check.

In recent years, the vigilantes have been dormant against the backdrop of trillion dollar deficits. A lack of near-term inflation anxieties are playing a role.

Those inflation bond vigilantes may now be morphing into the "QE vigilantes," as they launch waves of bear raids on the market, hoping to slow growth and force the Fed to keep the liquidity hose aimed at the bond market.

Fisher is standing in the gap.

The Fed's 360 degree door

Today's testimony by Fed Chief Ben Bernanke, as well as the minutes from the latest Fed meeting released later in the day, gave central bankers a door to pursue any number of policy options.

Let me explain. Early today, Bernanke testified before a Congressional committee that a premature tightening of monetary policy would carry substantial risks.

Got it. The Fed won't be paring back on bond purchases anytime soon.

Then, during the Q&A session, Bernanke said the Fed could reduce QE in the next few meetings, but added that it all depends on the data. Hmmm.

Muddy minutes
To make matters even more interesting, the Fed's minutes included this statement.

"A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth; however, views differed about what evidence would be necessary and the likelihood of that outcome."

But the minutes also referred in a number of instances to "downside risks."

So Bernanke is warning against a premature tightening, but a number of participants are expressing a willingness to cut back on bond buys, possibly by June.

Confused? The Fed sure seems divided. Or maybe it just doesn't want to clearly communicate when it might be start to taper off as it is worried the Street would quickly price in any exit.

Bottom line - the Fed has shifted the gravity of its position towards tapering off, but it has kept the door open to any number of policy responses if conditions warrant. It's a policy for all seasons.

The Fed–shoot now, ask questions later

The markets had anticipated the Fed would act, but the magnitude of the FOMC’s open-ended commitment to increase its balance sheet was met with a bullish stampede today.

And it wasn’t just stocks. Oil, gold and a host of other commodities gained ground.

The Fed is trying to reflate, and it won’t stop until it sees substantial progress in the labor market. In fact, the Fed’s statement was clear:

“If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”

So it's not just looking for improvement. The Fed will continue its bond purchases until it sees "substantial improvement."

At least publicly, it does not believe it will materially add to inflation, but the key question is whether its latest path will aid the economy and move the needle on the unemployment rate.

QE1 and QE2 - or $2.3 trillion in bond buys - have failed to significantly lift the economy. Bernanke even acknowledged in his press conference that "I don't think our tools are that strong."

The Fed chief has said before that monetary policy is not a panacea, but that was an interesting remark as the central bank embarks on a new chapter.

The 3 E’s–Earnings, Economy and Europe

While investors brace for the upcoming earnings season, Europe, and Spain in particular, are still on the radar, while the economy remains front and center.

Sluggish growth has liquidity-addicted traders hoping for a lifeline from the Fed, but the latest minutes the last meeting offered few concrete signs that a new burst of liquidity is on the way.

A few Fed members thought “further policy stimulus likely would be necessary,” but  several others felt new actions “could be warranted if the economic recovery were to lose momentum.”

The Fed will never send a definitive signal of future action, but traders were hoping for something a bit stronger.

With interest rates at a record low, however, many doubt a flood of new cash into the financial system would have much impact on the real economy.

Bernanke talks unemployment

Ben Bernanke's primary focus in today's speech - the unemployment rate.

While some in the press attribute today's advance in equities to Bernanke's positive spin on the recent decline in the unemployment rate, I tend to believe that his caveats temper his optimism.

Bernanke called the "notable decline in the unemployment rate" to be "good news," but immediately added, "some key questions are unresolved." And he's not optimistic that the recent rate of decline will continue unless we see a pick-up in growth.

What may be driving equities today (Treasury yields are higher), his remark that the "Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well” may be the primary driver.

And he reiterated at the end of his speech that "accommodative policies to support the recovery will help address this problem (cyclical unemployment) as well."  He clearly didn't back away from some new form of QE3, but it's a tougher calls as to whether he inched back toward it (gold is up). Goldman Sachs, for examples, expects QE3 sometime in Q2.

Finally he cited three possible explanations for the recent dip in unemployment.

• The first two, he mostly dismissed: GDP data will be revised upward and discouraged workers have left the labor force. He did not, however, provide much explanation on the substantial decline in the labor force participation rate.

• The third explanation - firms fired too quickly in 2009 and are now playing catch-up - was his most likely reason for the recent dip in the employment rate (see chart below from Bernanke's speech)

While Bernanke believes much of the still-high rate of unemployment is cyclical and not structural - and I agree - I tend to disagree with his assessment that firms laid off too quickly in 2009  - see chart below:



The drop in GDP matched the drop in nonfarm payrolls.

Since Bernanke believes the high rate of unemployment is being caused primarily by a lack of economic growth, QE3 remains an option. And this has implications for bond yields, money markets, CDs etc.

Of course, it also has implications for stocks and potentially commodities.

Fed statement–little change

A very quick and cursory look at the just-released Fed statement - 2:15 pm ET - revealed mostly a carbon copy of January's statement. And maybe just a slight upgrade in the outlook.

The Fed said:

• the economy is expanding moderately and it expects moderate economic growth over the coming quarters.
• the unemployment rate has declined notably but going forward, it anticipates just a gradual drop
• higher oil and gasoline will have just a temporary impact on inflation before it eventually slows (added)
  • With the economy still on an uneven footing, would the majority on the Fed really acknowledge a concern about inflation? Seems unlikely as that would force their hand and it would send LT rates soaring.
• no changes in any language regarding a third round of QE

None of this is really any surprise.

The Fed may just be setting the stage for something more significant at its two-day meeting in April (March's was just a day).

Final demand, which has befuddled policymakers given the relatively upbeat nonfarm payroll numbers, may hold the key for any new round of easing.

Sterilized bond buys appears to be the most likely part if we have a new move.

Retail sales
Good news on the retail front this a.m., and the upward revisions to January were welcome. But taken together with the weakness in Nov and Dec, it's steady as she goes. Still, I'll take upbeat numbers at the margin any day.

All this suggests the consumer is feeling better moving into the new year, as higher consumer confidence translates into more spending, despite the surge in gasoline prices.

Fed opens door wider to QE3

We're not there yet but comments coming out of yesterday's Fed meeting strongly suggested that the Fed will eventually implement a new round of QE3.

None of this should come as a surprise since a majority of Fed voting members have been bemoaning the high rate of unemployment for a while.

Sure we've seen a modest pick up in growth since the summer, but progress on unemployment has been slow, and publicly, that is the Fed's reason for its focus on QE3.

Economic projections are far from rosy

1. Sluggish GDP growth. In fact, a slight dip in the GDP forecast from Nov.
2. Slow progress on unemployment.
3. Subdued inflation within the Fed’s target.

In Bernanke's opening statement of his press conference, he said the Fed is "prepared to provide further monetary accommodation if employment is not making sufficient progress towards our assessment of its maximum level, or if inflation shows signs of moving further below its mandate-consistent rate.”

So if inflation slips some, the Fed has the extra wiggle room to buy bonds. Helicopter Ben couldn't pass up that opportunity!

And he added in a follow up to a question that QE3 is an “an option that’s certainly on the table.”

Fed begins two-day meeting against weak backdrop

The Fed began its two-day meeting today and will conclude tomorrow against the backdrop of a floundering economic recovery and a jobless rate north of 9%.

Most analyst believe the Fed, which pledged to hold rates low until at least mid-2013 at the August meeting, will take another step toward easing in the hopes of jump-starting employment growth.

Promising to hold rates low for another two years appears to have done very little for the economy and many believe new steps will have just a limited impact.

The Street expects the Fed to extend the length of its bond portfolio, popularly called “Operation Twist,” by swapping shorter-term debt for longer-term debt.

Theoretically that might lower longer-term rates.

But how much this is already priced into the yield curve is unknown, and long-rates are already at historic lows – a 4% 30-year fixed rate mortgage. And potential home buyers aren’t jumping at the bait.

So it stands to reason that even lower rates would have just a muted impact on the economy.

Despite expectations, correctly calling what the Fed may do can be as dicey as calling the offensive play on third and goal at the five.

Will it be a run up the middle, sweep around the end, QB rollout and pass? Maybe it’s not that tricky but it’s possible the Fed could surprise.

A full-blown QE3 – always a possibility – could be implemented, but the track record for QE2 – higher inflation and anemic growth – suggests we’d get even less bang for the buck this time around.

The Fed could cut the rate it currently pays on excess reserves (near $1.6 trillion) from 25 basis points, as it hope to encourage lending.

However, lending institutions are already forgoing higher rates on credit cards, mortgages, auto loans and business loans by earning just a paltry 25 bp!

Cutting the rate by 10, 20 or the full 25 would provide little incentive to lend when many are shying away from new debt.

Further eliminating the rate on excess reserves could make it more difficult for the Fed to manage the fed funds rate.

Unfortunately for the millions who remain jobless, the Fed has few credible options left in its arsenal.

Bulls sniff out another round of Fed easing

Fed Chief Ben Bernanke’s talk on Friday at Jackson Hole, WY will likely be the event of the week given the recent unexpected weakness in the economy and the many debt problems that are plaguing Europe.

Clearly, this has tripped up the bulls over the last month, taking a big toll on equities and lending a helping hand to Treasuries.

But Monday and Tuesday have come as a big relief to investors, especially the strong advance yesterday.

Many traders tend to take the final week or two of August off, and a potential lack of liquidity may be accentuating the market moves.

Bargain hunting – stocks appear to be cheap if you are betting against a recession or a near-term default in Europe – is likely a contributor to the rally.

But the biggest reason, in my view, is the lack of any damaging headlines out of Europe and the expectation that Bernanke’s Fed is ready to come to the rescue with more talk of easing.

Recall that Bernanke first hinted at what would eventually be known as QE2 at last August’s meeting in Jackson Hole. That surprised markets.  And he surprised them again in early July by lowering the bar for implementing a more aggressive monetary policy.

Inflation is higher today than a year ago but this time around, the economy is unusually fragile.
Stocks have become addicted to regular Fed injections of liquidity, and another sugar high – compliments of the central bank – seems like a good short term fix.

But the last round of QE did little for the real economy since the $600 billion in new money is currently being held by banks and is on loan back to the Fed in the form of excess  reserves.

And inflation in the U.S.is higher today while emerging market economies like India and China are hiking rates in order to contain rising prices.

The Fed may try to surprise markets by calling for further unconventional action or measures that haven’t been publicly discussed, but the last round of QE was counter-productive since it exacerbated commodity inflation and contributed to higher rates overseas, which has slowed U.S. exports.

Dow tumbles 635 points in wake of S&P downgrade

What an awful day on the Street.  In the wake of S&P’s downgrade of U.S. sovereign debt on late Friday, global markets, and the U.S. in particular, reacted violently to the country’s loss of its cherished AAA rating.

Never mind that the downgrade had been telegraphed in advance.

Never mind that Standard & Poor’s had been the U.S.’ harshest critic on deficit spending, stating a month ago that there was a 50-50 chance of a downgrade if a $4 trillion plan was not put in place.

Never mind, as Bloomberg News noted, that France, Germany and the U.K., which still hold the coveted rating, all have CDS costs – or insurance against default – that is higher than that of a U.S. Treasury note.

Still, the timing of the downgrade could not have come at a worse time, as heightened recession concerns and growing debt woes in Europe took a huge toll on the market last week.

Not surprisingly, gold prices jumped in reaction to the instability, but interestingly, investors also sought safety in Treasuries, despite the opinion by S&P that government debt no longer warrants the gold-standard AAA rating.

Without question, Bernanke’s Fed has been very closely watching the fluid situation in the financial markets, as well as the recent spate of weak economic data and the still-unfolding situation in Europe.

QE2, when it was all said and done, had little impact on the real economy, and the jump in stock prices we saw earlier in the year, which Fed officials were happy to trumpet, has all but evaporated.

Further, the extra cash the Fed injected into the system exacerbated commodity inflation, which has hurt the economy.

That doesn’t  mean equities, which are looking for their next fix from the Fed, would shun another infusion of central bank liquidity.

It only means that it’s a temporary solution to a bigger problem. We’ll know more on Tuesday at the conclusion of the Fed’s meeting.

Collapse in longer-term Treasury yields sends ominous signal

Stocks are falling and investors are running into the arms of Treasuries, seeking safety in the midst of economic turmoil.

Not what one might have expected last month amid fears that the growing federal budget deficit might scare away foreign buyers.



We can discern two things:

1. The U.S. Treasury market remains a safe-haven, even as the U.S. budget deficit explodes.
2. The bond market is running scared, fueled by fears that another recession is imminent.

The weak economic data, starting with the downward revision to GDP, which was then followed up by a disturbing report on manufacturing, has definitely gotten the attention of Fed officials who had been anticipating a pickup in activity later in the year.

Throw in the sudden rush into Treasury bonds and you have wonder if Bernanke and Co. are starting to panic.

Jobs data on Friday may hold the key to whether the Fed will announce new plans to boost the economy.

Inflation expectations have not plummeted along with Treasury yields, but at this juncture, you have to say the odds seem to favor some type of action.

Falling gasoline prices mask rise in core CPI

The CPI, or Consumer Price Index, fell 0.2% in June as expected amid a 4.4% decline in energy prices, including a 6.8% decline in gasoline prices.

Food costs were also well behaved, rising just 0.2% last month, the smallest increase since last December.

But falling energy prices last month masked an overall upward trend in retail inflation.

The core CPI, which excludes the more volatile food and energy categories, rose 0.3% in June, the second such monthly increase in as many months.



Year-over-year, the CPI held steady at 3.4%, while the core CPI edged up from 1.5% to 1.6%.

At 1.6%, core inflation, which has been creeping higher, appears to be relatively well behaved. But the y/y rate does not reflect the recent jump in the broader price level.



Thanks mostly to higher auto and apparel costs, core inflation is up 3.0% at an annualized pace over the last six months, according to government data.

That’s well above the Fed’s implied target of just under 2%! Of course, I'm not comparing apples to apples, i.e., y/y versus a six month annualized pace, but the recent uptick, though transitory in the Fed's view, is a bit troubling.

QE3 chatter
On Wednesday, Fed Chief Ben Bernanke opened the door to another round of monetary easing, offering three different options – two of which have largely been untested.

Stocks reacted favorably but Bernanke dampened enthusiasm on Thursday.

“We’re not prepared at this point to take further action,” Bernanke told a Senate panel yesterday in his Q&A session, per Bloomberg news.

“Today the situation is more complex,” he told lawmakers. “Inflation is higher. Inflation expectations are close to our target.”

With core inflation moving forward at an annualized pace over the last six months of 3%, inflation is up, which is complicating the Fed’s job.

A side note: In my view, the $600 billion in bond purchases between November and June have played a significant role in rising commodity prices (see QE2 and its economic impact – chart 2).

And businesses, which still must deal with fragile aggregate demand, have had some success in passing along higher costs.

So it was not surprising to hear Bernanke put the brakes on QE3 chatter, especially since, there was a two month gap between the first mention of new bond buys and the actual implementation of QE2.

The Fed will continue to closely monitor economic activity, especially job creation. And if we continue to see weak growth, odds of  a policy shift will rise.

Bernanke acknowledges additional options on the table

Fed Chief Ben Bernanke moves to the Senate today after testifying before a House Committee on Wednesday.

Much of the prepared remarks were generally anticipated: weaker-than-expected recovery is probably temporary, spike in inflation probably transitory and weakness in job market, consumer spending and housing were all mentioned.

And of course, recent Fed actions to support the economy were a part of his written testimony.

Bernanke had recently commented that another round of easing by the Fed is unlikely, implicitly suggesting that the hurdle for QE3 or some other type of unconventional easing is quite high.

But yesterday’s comments caught the market off guard, indicating that Bernanke has lowered the bar.

The Fed Chief reiterated that he expects economic activity will pick up during the second half of the year, as factors that have dampened growth subside.

Still, policymakers at the Fed are concerned that the recent weakness could persist, as Bernanke added that the outlook is unusually uncertain.

In his own words, he said, “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.”

He went on to list three possible options that remain in the Fed’s arsenal.

1. Provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels.
2. Initiate more securities purchases or increase the average maturity of its holdings.
3. And finally, the Fed could cut the rate it currently pays on bank reserves held at the Fed – 25 basis points – in the hope that it might put downward pressure on short-term rates more generally.

I might add that the Fed hopes a cut in reserve balances would encourage some banks to loosen lending standards and open up to businesses and consumers.  With excess reserves at $1.6 trillion (see QE2 and its economic impact – chart 2), there’s plenty of dry powder in bank vaults to fuel economic activity.

In reality, this shouldn’t have been as surprising as it first appeared since the FOMC minutes out on Tuesday revealed the heightened level of uncertainty among Fed officials.

On the one hand, they offered up a detailed plan for an exit strategy, but some members noted, “The Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run.”

Bernanke was quick to admit that “experience with these policies remains relatively limited, and employing them would entail potential risks and costs.”

He’s right and one must ask, “Will such additional stimulus work, or are we in a liquidity trap where extra cash that’s injected into the economy does little to influence interest rates?"

Deflationary risks – extremely small
I disagree with Bernanke’s assertion that deflationary risks might re-emerge.

Oil prices are near $100 per barrel and raw materials in general, though off their highs, remain at a very elevated level. Inflation expectations, which cratered last summer, are more stable this time around, and we're still seeing solid growth coming out of China based on its latest GDP number.

Further, businesses are still grappling with higher input costs, and the uptick in core inflation bears this out.

Nonetheless, the Fed is keenly aware of the uptick in the unemployment rate and the considerable slowdown in job creation.

I had suspected it might take a month or two of weak job growth before the Fed publicly discussed the possibility of a third round of easy, but the troubling slowdown and resulting weakness in hiring has tipped the Fed’s hand.

If I had to take an educated stab at what will eventually happen, weak job creation through July and August seems to be the most obvious path. And that is going to be upper most on the Fed’s mind.

But the uptick in core inflation is troubling and further easing could quickly cause renewed speculation in commodities, putting additional pressure on core inflation.

Still, just telegraphing the possibility to the financial markets suggests at least a 50% chance of some type of shift in policy.  Look for comments from regional Fed officials in the near term for clarity.

FOMC minutes reveal members discussed the ‘how to’ but not when for an exit strategy

The June 21-22, 2011 meeting of the FOMC – Federal Open Market Committee – met against the backdrop of slowing economic activity, a pick up in core inflation, which it still believes is temporary, and growing fears that one or more countries in Europe might default on their debt.

The FOMC minutes noted that growth in consumer spending has declined, the labor market has softened, and activity in the housing market remains depressed.

Exit stage left
At the conclusion of the meeting, the FOMC decided that when the time comes to begin normalizing policy, it plans to:

1. Stop reinvesting some or all principal repayments
2. Modify its forward guidance on the path of the fed funds rate and initiate temporary reserve-draining operations aimed at supporting the implementation of increases in the fed funds rate when appropriate
3. When conditions warrant, begin raising the target for the fed funds rate
4. Sale of agency securities likely to begin sometime after the first hike in the fed funds rate, with timing and pace communicated to the public in advance
5. Once sales begin, the pace of sales is expected to be aimed at eliminating the holdings of agency securities over a period of three to five years
6. And finally the FOMC stands ready to adjust its exit strategy depending on economic and financial conditions.

The template provides the investing public with guidelines, but there was not indication as to when such an undertaking might begin.

Currently, the Fed is battling a slowdown in economic activity and an acceleration in core inflation.

Further increases in inflation would greatly complicate the Fed’s job of promoting its statutory mandate of maximum employment and price stability.

Commodity prices have jumped, which is fueling the rise in inflation, but wage gains have been stagnant, and excess capacity and subdued demand suggest any further and unwanted gains in inflation are probably not on the horizon.

Additionally, the Committee pointed out that longer-run inflation expectations remain stable.

Most participants expected that much of the rise in headline inflation this year would prove transitory, and inflation over the medium term would be subdued as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable.

Nevertheless, a number of participants judged the risks to the outlook for inflation as tilted to the upside. Moreover, a few participants saw a continuation of the current stance of monetary policy as posing some upside risk to inflation expectations and actual inflation over time.

But Committee members were divided on what to do.

On the one hand, a few members noted that, depending on how economic conditions evolve, the Committee might have to consider providing additional monetary policy stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run. QE3?

But a few members viewed the increase in inflation risks as suggesting that economic conditions might well evolve in a way that would warrant the Committee taking steps to begin removing policy accommodation sooner than currently anticipated.

Consequently, the Fed stayed on its expected path, signaling it will hold the fed funds rate at the current level for an extended period and concluded the meeting by stating it will end its planned purchases of $600 billion in Treasuries by the end of June.

QE2 and its economic impact

The Fed’s controversial and much-maligned program to buy $600 billion in longer-term Treasuries, popularly known as QE2, came to an end last week as the central bank made its final purchases of bonds.

The decision by the Fed to launch into a second round of bond buys came in early November, but Fed Chief Ben Bernanke first publicly toyed with the idea at the end of August.


Source: Bloomberg, Federal Reserve

Last summer, the economy was suffering through an economic slowdown and talk of a nasty bout with deflation was rising.

In order to stimulate economic growth, boost inflation expectations and erect a deflationary firewall, the Fed eventually decided to implement a round of bond purchases that would boost liquidity by hundreds of billions of dollars.

Stocks prices reacted favorably but the extra cash also seems to have founds its way into commodities (chart above).

Currently the core CPI is running at an annualized pace of 3.0% over the last three months.



But has the extra cash founds its way into the real economy?

The second chart would strongly suggest it has not.

Excess reserves, defined as funds that are over and above what banks must hold in order to satisfy withdrawal needs of their customers, have soared by about $600 billion – in line with the extra cash the Fed created to buy its Treasury bonds.

Reserves stood at nearly $1 trillion before QE2 was implemented, and it should come as no surprise that the additional liquidity has done little to bolster the real economy (see Excess reserves and heightened uncertainty – Sept 27, 2010).

Liquidity trap?  If we’re not there, we sure are close.



No matter how much money the Fed floods into the economy, the central bank is unable to affect interest rates, i.e., a liquidity trap.

Fed cuts forecast on GDP, as Bernanke comments pressure stocks

"You're on your own"

There weren’t any big surprises to come out of the Fed’s press release that followed the conclusion of its two-day meeting.

The FOMC acknowledged the slowdown in the economy, telegraphed that interest rates aren’t going higher anytime soon, will no longer expand its balance sheet and believes the growth will eventually accelerate. A cut and dry look is available at Examiner.


(Source: Fed)

Further, the Fed also cut its forecast on GDP growth for the second time this year.  Unfortunately, the FOMC expects unemployment to remain uncomfortable high through the end of 2013.


(Source: Fed)

What did seem to catch the markets off guard occurred in the press conference that followed the FOMC meeting.

The Fed noted in its press release, “The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan.”

'In part' implies there were other factors impacting the economy and an astute reporter quickly picked up on this, asking what else might be responsible for the sluggish recovery.

Bernanke responded that monetary officials don’t have a precise read as to why slower pace is persisting. But some of the headwinds that are of concern included “weakness in the financial sector, problems in the housing sector, balance sheet and deleveraging issues.”

He added that some of these headwinds may be stronger and more persistent than “we thought.”

Of course, questions about Europe and Greece surfaced and the potential impact on the U.S.

Bernanke said the Fed has been “very assiduous” in examining the exposures financial institutions have countries that have been plagued by debt issues.

U.S. banks are not significantly exposed to those countries, including Greece, as direct exposure is “pretty small.” Exposure is larger in the more stable countries, such as Germany and France.

The same holds true with money market funds. Exposure is minor in peripheral countries but there is substantial exposure in European banks in so-called core countries, Germany, France etc.

Not surprisingly, Bernanke said a disorderly default would “no doubt roil financial markets globally would have a big impact on credit spreads (thus far, its been minor), stock prices and so on. Effects in US would be quite significant.”

It’s the disorderly default the Fed is hoping to prevent.

Bernanke to economy: You're on your own
Well, Bernanke didn't utter those words, but one has to ask, "What has the Fed chairman done?"

Bernanke took credit for eliminating the small but growing threat of deflation that was emerging last summer and noted that job creation picked up amid the QE2 bond purchases.

Other than that, the Fed chairman seemed more like a deer in the headlights, conceding that growth is slowing and some of the causes may be more than temporary.

He offered little solace to those of have been heavily impacted by job losses or those who've yet to see stock and retirement portfolios fully recovery from the 2008-09 bear market.

In other words, monetary policy has its limits.

Inflation expectations still anchored

Headline inflation has turned higher since the start of the year amid a jump in food prices and sharply higher gasoline prices.

But it’s not just food and energy.  Commodity prices in general have surged on strong demand from China and emerging markets, while the Fed’s $600 billion in purchases of longer-term Treasuries, popularly known as QE2, also appears to be part of the problem (see QE, commodities and stocks).



An ultra-loose monetary policy, coupled with sharply higher raw material prices, has given way to talk among analysts and the public that much higher inflation is all but a certainty.

Anecdotal evidence from the Fed and a smattering of corporate earnings reports during Q1 do suggest that pricing power is beginning to emerge, and regional surveys of manufacturing by various regional Fed banks are detecting some movement in prices that manufacturers receive.

The University of Michigan’s survey of consumer sentiment, which includes inflation expectations, has detected upward movement in the public’s view of what will happen to inflation over the next year.

Further, core inflation has crept off the bottom.

But the longer-term inflation outlook – see chart, as measured by the ten-year break-even rate of inflation (the difference between the yield on the ten-year bond and ten-year TIPS, shows that inflation expectations remain reasonably anchored.

The reason it is called the break-even rate of inflation? The spread reveals what Treasury buyers are willing to give up in order to obtain a hedge against inflation.

Though not perfect, it does provide a rough look at the longer-term inflation outlook.

Expectations have moved higher since Bernanke first announced at the end of August that the Fed was considering a new round of bond buys. Notably, prior to Bernanke's announcement, inflation expectations has been cratering amid deflation chatter and growing worries about a double-dip recession.

But the spread is now near a five-year high.

Still, at just under 2.50%, investors have not lost confidence that the Fed can sop up the extra liquidity it has put into the financial system and prevent inflation from taking hold when growth eventually picks up. Plus, nascent worries about growth and mixed data have knocked off almost 20 basis points off the recent high.

And the relatively low level of inflation expectations is what gives the Fed the leeway to continue to hold rates at rock bottom levels and keep its primary focus on economic activity and job creation.

QE, commodities and stocks

The Federal Reserve announced its first foray into QE, or quantitative easing, when it communicated to the public at the end of November 2008 – see statement – it would buy up to $100 billion in GSE obligations and up to $500 billion in mortgage-backed securities.

Falling commodities and stocks, surging unemployment and emerging fears that deflation might eventually engulf the economy led the Fed to vastly expand QE, now  referred to as the first round of quantitative easing, as it now included $1.5 trillion in agency debt and mortgage-backed securities purchases and $300 billion in Treasuries.

Initially set up to go through December 2009, the Fed decided to extend and draw out the purchases of agency and MBS until the end of Q1 of 2010 in order to smooth transition in the markets – see statement.


(click chart to enlarge)

Defined as the purchases of government debt over and above what is needed to keep short-term rates at zero, the Fed’s extraordinary action has prevented a much deeper recession from taking hold.

But the  massive purchases have had little impact stimulating a more aggressive recovery, as much of the newly created money returned to the Fed in the form of excess reserves – Economic impact of QE2 looks limited.

Nonetheless, as the chart above reveals, the implementation of both QE1 and QE2 does appear to have had a profound impact on commodities and stocks.

Commodity prices (orange), as tracked by the Thomson Reuters/Jefferies CRB Index, didn’t bottom until Q1 2009 as risk averse investors shunned all but the safest assets, while a sharp slide in global manufacturing triggered a surplus of raw materials.

The end of QE1 marked the temporary end to the rise in raw material prices. In fact, the decline during the first quarter of 2010 can probably be traced to declining purchases of government securities and the expectation new buys were about to come to an end, as Fed moneys dried up.

The blow up in Greece during the spring of 2010 and the modest impact on the credit markets encouraged investors to briefly trade their commodities and stocks for the safety of the dollar.

However, the mere mention at the end of August 2010 by Fed Chief Ben Bernanke that policymakers were considering a second round of QE2 sent astute speculators back into the commodity markets.

And the eventual implementation of $600 billion in longer-term Treasury buys has helped to fuel the dramatic rise in raw material prices.

Stocks (green), as measured by the S&P 500 Index, have tracked a similar path, with the bull market being interrupted by the end of QE1 and the negative effect of the credit crisis in Greece on economic activity and financial markets.

The avoidance of a double-dip recession last year and the favorable impact from a growing economy on corporate profits has reignited bullish sentiment; however, the flood of new Fed money has also provided a stiff tailwind for stocks, in my view.


(click chart to enlarge)

A closer look at the CRB Index and the first and second rounds of QE are available in the chart above.

Fed still transitory on spike in inflation

The Fed was pretty clear where it stands on the recent spike in inflation from extremely low levels.

In its statement, the FOMC said: “Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March.  Inflation has picked up in recent months (a new addition to the statement), but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.

The Fed added, “Increases in the prices of energy and other commodities have pushed up inflation in recent months.  The Committee expects these effects to be transitory.”

It’s the publicly stated belief that higher gasoline and other commodity prices won’t stoke a new round of unwanted inflation which pushed the dollar down and gold and silver prices higher in late afternoon action.

Traders believe that Bernanke is not taking a hard enough line on surging commodity prices.

But wage gains remain stable and there’s still some slack in the economy, and that does give the Fed some leeway.

Moreover, Bernanke’s focus is on the tepid pace of the economic recovery, and a hawkish shift in the Fed’s stance is unlikely as long as unemployment remains high and job creation does not substantially accelerate.

Given a ten-year Treasury yield that is below 3.40%, the bond market is more in sync with the Fed, even if gold and the dollar are not.

Still, there are always risks to the outlook, and Bernanke is willing to gamble on an uptick in the core rate of inflation if it means a more robust recovery.