With June and the end of Federal Reserve bond purchases fast approaching, the question that must surely be growing in the minds of global traders, policy-makers concerned about food inflation or anyone that gives a hoot about Australia’s non-resource exports is ‘will Ben do it again?’ By that, this blogger means Ben Bernanke and the prospect of QEIII.
On the “yes” side of the argument, we first have Bernanke himself, who late last week declared himself free of guilt regarding the inflationary consequences of QEII:
“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to US monetary policy, because emerging markets have all the tools they need to address excess demand in those countries … They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases.”
Also clearly in the “yes” camp is Paul Krugman, who has been doing his absolute best to absolve the Fed of any responsibility for food price hikes. Yesterday, he pointed the finger squarely at global warming:
The usual suspects will, of course, go wild over suggestions that global warming has something to do with the food crisis; those who insist that Ben Bernanke has blood on his hands tend to be more or less the same people who insist that the scientific consensus on climate reflects a vast leftist conspiracy.
As a brief aside, this blogger will confess that he believes in global warming but does not believe Paul Krugman.
Back on topic and next in the “yes” camp is a superlative argument by Gavyn Davies of the FT written over the weekend that made a systemic case for why Bernanke will ignore commodity inflation:
This, then, is the orthodoxy. Spare capacity (usually measured by the output gap) determines the core inflation rate. Increases in commodity prices can, from time to time, lead to variations in the headline inflation rate, but these will fairly quickly be eliminated as long as the central bank remains focused on the long term path of the core inflation rate. The two most significant danger signals would be an increase in price expectations, or a rise in wage settlements. Since neither of these signals is flashing red, or even amber, in the US, the Fed remains super dovish. In fact, someone described it recently as “uber” dovish.
So, it’s fair to say that neither global politics nor commodity inflation will deter QEIII.
However, if we turn to Tim Duy, the persuasive master of FedWatch, we also find the output gap argument, but this time it’s deployed in the “no” corner:
The January employment report was a mess, but the sharp drop in unemployment is difficult to ignore, especially given the general better-than-expected tone of recent data. At this junction, I believe it is reasonable to believe that overall activity will prove to be better than expected by Federal Reserve policymakers. Still, an upward revision to the forecast does not alone imply that Bernanke & Co. will find it imperative to return to the question of when to tighten. The output gap remains strikingly large for an economy in expansion since the middle of 2009. That should be sufficient to leave the baseline forecast of steady policy intact. But incoming data suggests the balance of risks is no longer on the side of disappointment. It may be that, for the first time in four or five years, the pessimists will need to find a new hobby.
And adding further strength to the “no” camp is Econompic who last week offered a superbly concise take on US Q4 GDP:
Pretty wild release. HUGE positive impact (more than 3%) by improvement in net exports. HUGE positive impact (more than 3%) by consumption (strong demand in durable and non-durable goods). HUGE negative impact (almost 4%) by inventory liquidation to meet final demand vs. new production
I’ve been looking for a bump in aggregate global demand and the jump in consumption and net exports is a good sign. In addition, the fact that we have met final demand by depleting inventories, once again feeds the cycle that businesses have to ramp up production to meet final demand going forward (which will positively impact future economic growth).
So, for the first time since the GFC, we have the makings of a self-sustaining business cycle in the US. But it is dependent, at least partially, on a continued surge in exports. Which is, in turn, dependent upon a weak $US and global rebalancing in the form of greater Chinese demand.
We can of course turn this over and argue that given Chinese currency recalcitrance, the primary mechanism for keeping the $US low is more monetary easing. However, with this blogger’s thesis that Chinese growth will continue to blow off this year, as well as strong demand in other emerging markets, there is a solid prospect that US exports will keep growing anyway.
The deciding factor for QEIII, though, will be unemployment. That was the principle rationale behind QEII. The consensus, so far as this blogger can tell, is that the US January employment report was better than the headline numbers suggested. Calculated Risk summarised it thus:
This was a decent report with two obvious exceptions: the few payroll jobs added, and the slight decline in the average workweek – both potentially weather related.
The best news was the decline in the unemployment rate to 9.0% from 9.4% in December. However this was partially because the participation rate declined to 64.2% – a new cycle low, and the lowest level since the early ’80s. The participation rate has now fallen 2 percentage points during the recession – a huge decline.
The 36,000 payroll jobs added was far below expectations of 150,000 jobs, however this was probably impacted by bad weather during the survey reference period. If so, there should be a strong bounce back in the February report.
The decreases for the long term unemployed, and for the number of part time workers for economic reasons, are good news – although both levels are still very high. The average workweek declined slightly to 34.2 hours (possibly weather related), and average hourly earnings ticked up 8 cents.
If we blame it on the weather, this was a solid report. And we will know about payrolls in February.
So, what should we conclude then? Clearly, there is no chance of the Fed raising interest rates in 2010. And only a creeping chance in 2011. Second, QEIII must surely remain a temptation and will not be inhibited in the slightest by commodity prices. Moreover, it is probably fair for the FOMC to conclude that QEII has worked (at least in the short term). The S&P500 has enjoyed an extraordinary straight line rise since Bernanke mooted QEII in his Jackson Hole speech of late August. Which was one Bernanke’s stated aims:
Against this, if there are decent employment gains over the next few months then the rationale for more QE will be drowned out by the screams of the inflationista, which have already begun amongst fringe Fed presidents. US long bonds are also looking restless, but are yet to decisively signal any inflation concern. Besides, Bernanke has already intimated his intention to target higher inflation.
So, that is this blogger’s ultimate advice, watch the US employment numbers.
Would an end to QE shock markets? Perhaps initially, but this blogger isn’t so sure. ZIRP would still be intact and with little prospect of actual rate rises, the reflation dynamic of inflating emerging markets and commodities will continue, with the $US suppressed. The reflation dynamic feels very powerful now, as shown by the shrug markets gave today’s Chinese rate rise.
For the $US to genuinely reverse and disrupt this dynamic, this blogger reckons we would need a crisis of some sort (which would probably trigger QEIII anyway), or a shift in the global recovery narrative toward US-led growth. Given all of the above, that still seems remote.