What can I tell you? The great boob has delivered. The great baby is lapping it up. QE3 is coming!
That’s the simple truth screamed by markets following Ben Bernanke’s testimony last night. The Dow went berko, the $US got trashed, gold hit record highs and commodities (oh commodities!) went limit up in everything from oil to rice.
But, notwithstanding risk trade euphoria, pretty much every international commentator of repute has interpreted Bernanke’s comments as signaling no QE3. What gives?
Let’s start Bernanke himself. The money paragraph of his testimony stated that:
Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.
Now to Jon Hilsenrath of the WSJ, generally considered something of a Fed mouthpiece:
Chairman Ben Bernanke acknowledged in his House testimony today that the Federal Reserve might need to take additional steps to ease monetary policy. “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 said.
This represents a slight shift in tone for the Fed chairman. In a press conference in June, Mr. Bernanke, in response to a question, laid out what the Fed COULD do if it saw a need to provide more stimulus to the economy. In his testimony Wednesday, he effectively said more stimulus MIGHT be needed, but only under certain conditions, namely persistent slow growth and a slowdown in inflation that again raises the prospect of Japan-style deflation.
Binyamin Applebaum of the NYT times is even less sanguine:
The Federal Reserve chairman, Ben S. Bernanke, gave a subdued account of the economy’s health Wednesday, saying that he expected the economy to grow at a moderate pace during the rest of the year, with unemployment declining “only gradually.”
The unexpected weakness is forcing the Fed to reconsider its determination early this year to refrain from new efforts to stimulate growth. While no additional actions appear imminent, Mr. Bernanke said in Congressional testimony Wednesday that the Fed would be prepared to act if necessary.
…Mr. Bernanke made clear Wednesday that a resumption of the central bank’s economic revival campaign faces a high hurdle. He said that the Fed would look for two conditions: economic weakness beyond current expectations and a renewed threat of deflation.
The first seems obvious to most people. The second, however, may the more important factor. The Fed’s decision to resume asset purchases last summer was made in large part because the central bank feared that prices might begin to decline, a phenomenon that can undermine growth because it causes people to delay purchases, fueling a downward cycle.
The FT took things the same way. Heavy hitters Gavyn Davies and Tim Duy did too (though the latter was addressing yesterday’s minutes). Both reckon that the Fed is badly divided and Bernanke unwilling to force though further stimulus. From Davies:
The financial markets seem determined to interpret today’s statement by the Fed chairman in a dovish light, but a careful reading of his words does not support that point of view. True, Mr Bernanke outlined the possible ways in which monetary policy might be eased further if recent economic weakness should prove more persistent than expected. But he gave equal weight to the possibility that “the economy could evolve in a way that would warrant less-accommodative policy”.
There was no hint in the text about which of these outcomes he considered the more likely. We already knew from yesterday’s FOMC minutes for the June meeting that the committee is split about the likely evolution of policy, and we were waiting to see today whether the chairman would throw his weight behind either the doves or the hawks. He failed to do either.
Mr Bernanke’s description of the economic background was almost exactly the same as he offered after the June meeting. Economic activity was described as weaker than expected, and not all of that weakness was attributed to temporary factors. In his central view, growth would rebound in the second half of the year, but there was considerable emphasis on the continuing weakness of the labour market. Meanwhile, on inflation, some of the recent rise was also attributed to temporary factors, but the entire emphasis was on the headline rate, which he said had been running at over 4 per cent so far this year. There was no mention whatsoever of the much lower core inflation rate, a previous favourite of the chairman’s.
In other words, his overall message was that the economy might be undesirably weak, but that inflation was too high for the Fed to be able to respond to that weakness. That is the main point which we should all take from today’s evidence: no imminent change in policy is likely.
Bernanke is caught in a trap of his own making. It he tells the truth, that the US economy is stuck in some slow motion depression, then the obvious consequence is more stimulus. But that same stimulus has now created such an extraordinary market expectation of an inflationary impulse through global commodity pricing that it reacts before he can stimulate, boosting inflation and preventing that very stimulus.
Basically, successive Bernanke QEs have de-anchored global capital market inflation expectations and that has stuffed his domestic mandate.
I see three possible scenarios.
First, the FOMC damns the lifeboats and delivers QE3, resulting in an epic blowoff in commodities and emerging market inflation.
Second, FOMC division persists and global markets continue to oscillate between hope and fear of free $USs.
Third, the FOMC sticks to its inflation busting guns and doesn’t stimulate until inflation expectations are re-anchored in markets.
The history of the FOMC still suggests to me that option one is the most likely.