by Don Alexander, MBA
Associate, RSD Solutions Inc.
The most important event this week is tomorrow's speech by Fed Chairman Ben Bernanke at the annual Kansas City Fed Conference. The speech is expected to focus on three elements: the downgrading of US economic prospects, a defense of past policy actions and an outline of Fed policy options.
Last year, Mr. Bernanke outlined details for QE II and Fed policy options: the purchase of long-term securities, communication and lowering the interest rate paid on excess reserves. The Friday speech will most likely focus on: the possibility of additional purchases of long-term securities and changing the composition of the balance sheet.
The Fed will note the downgrading of US economic prospects, as mentioned in the recent FOMC minutes. This view will be consistent with the lowering of US growth prospects done by a number of Wall Street (WS) analysts. The most recent FOMC communiqué noted “a slower pace of recovery in coming quarters” and “downside risks to the economic outlook have increased”. However, the Fed economic outlook has one key difference from WS analysts as evidenced in recent speeches by Fed officials “weakness in economic activity in the first half was due to temporary factors …” and “restraining forces have abated and thus, we should see stronger growth in the second half”. This suggests the Fed takes the view that the slowdown was partially caused by temporary factors. The Fed scenario is for weak growth followed by a modest recovery going into 2012. This is slightly more optimistic than private sector forecasts.
The next point, to be addressed by Mr. Bernanke, is the defense of previous Fed easing efforts. The combination of weakness in growth and downward revision to economic forecasts raise questions about effectiveness of recent policy efforts. Previously, he argued that QE helped reduce deflation risk and raised inflation expectations. Mr. Bernanke will most likely address these issues as follows: the first is that central banks (Fed) cannot be the sole source of stimulus in a global fiscal tightening environment; secondly, one way QE II was successful by avoiding another recession (to date) and deflation; and lastly there is evidence from economic studies that QE does have a positive impact on growth. The jury is still out on QE II, but it has helped the economy – the question is how much?
As indicated earlier, the three options open to the Fed include: communication, asset purchases and balance sheet management and changing the interest rate paid on excess reserves. The Fed has already implemented a variation of its communication policy by stating that rates will remain low for an extended period. The Fed will not consider changing the interest rates on excess reserves due to technical aspects of implementation, potential damage to banks from already low rates and questionable impact on bank lending.
This leaves the last option of large-scale asset purchases and changing the composition of the balance sheet. There are studies that suggest that selling short-dated treasuries and buying long-dated can have a significant impact on reducing real rates. The reason why this option may be favored is that it will not change the size of the Fed balance sheet which would keep politicians happy. The view among WS analysts is that Mr. Bernanke will present these options, but not pre-commit to any policy action except through the FOMC. The recent rise in core inflation will keep policymakers cautious. The use of any unconventional policy options such as a higher inflation target, price level targeting, a long-term interest rate target or option twist (used in the early 1960s) may be considered at a later date.
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