Markets sold off last night on the concern that Fed is not going to man the big QE3 pump. With good reason it seems, though there is still hope. We know that the dominant clique at the FOMC is concerned about inflation. However, in his speech overnight, Ben Bernanke made it clear, rightly, that the inflationary pulse in the US economy is cyclical only:
Let me turn now from the outlook for growth to the outlook for inflation. Prices of many commodities, notably oil, increased sharply earlier this year. Higher gasoline and food prices translated directly into increased inflation for consumers, and in some cases producers of other goods and services were able to pass through their higher costs to their customers as well. In addition, the global supply disruptions associated with the disaster in Japan put upward pressure on motor vehicle prices. As a result of these influences, inflation picked up significantly; over the first half of this year, the price index for personal consumption expenditures rose at an annual rate of about 3-1/2 percent, compared with an average of less than 1-1/2 percent over the preceding two years.
However, inflation is expected to moderate in the coming quarters as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs. Meanwhile, the step-up in automobile production should reduce pressure on car prices. Importantly, we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy. Longer-term inflation expectations have remained stable according to the indicators we monitor, such as the measure of households’ longer-term expectations from the Thompson Reuters/University of Michigan survey, the 10-year inflation projections of professional forecasters, and the five-year-forward measure of inflation compensation derived from yields of inflation-protected Treasury securities. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.
That seems to me to be a wide invitation for QE3. Any inflationary pulse will again be temporary so let’s go for it, as it were. But, there was another passage in the speech that worked against this conclusion:
The pattern of sluggish economic growth was particularly evident in the first half of this year, with real gross domestic product (GDP) estimated to have increased at an annual rate of less than 1 percent, on average, in the first and second quarters. Some of this weakness can be attributed to temporary factors, including the strains put on consumer and business budgets by the run-ups earlier this year in the prices of oil and other commodities and the effects of the disaster in Japan on global supply chains and production. Accordingly, with commodity prices coming off their highs and manufacturers’ problems with supply chains well along toward resolution, growth in the second half looks likely to pick up. However, the incoming data suggest that other, more persistent factors also have been holding back the recovery. Consequently, as noted in its statement following the August meeting, the Federal Open Market Committee (FOMC) now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the June meeting, with greater downside risks to the economic outlook.
So, now inflation is holding back growth through raised prices for goods but not wages. This is, again, absolutely true, and goes to the heart of what I’ve written on any number of occasions, that the FOMC is trapped as currently constituted. It can’t be both stimulator of last resort and inflation fighter of first resort at ZIRP.
The impotence of the Fed was made all the more clear by an article by widely regarded Fed mouthpiece John Hilsenrath at the WSJ, which showed the options under consideration for the two day Fed meet are pretty mild:
Federal Reserve officials are considering three unconventional steps to revive the economic recovery and seem increasingly inclined to take at least one as they prepare to meet this month.
…One step getting considerable attention inside and outside the Fed would shift the central bank’s portfolio of government bonds so that it holds more long-term securities and fewer short-term securities.
…A second step under consideration at the Fed, one getting mixed reviews internally, would reduce or eliminate a 0.25% interest rate the Fed currently is paying banks that keep cash on reserve with the central bank.
…A third step Fed officials are debating would involve using their words to make their economic objectives and plans for interest rates more clear.
As I wrote recently, we’re into a new realm of Fed signaling where price intentions are all we have left given the actual Fed funds rate is effectively zero, and moot. None of these options looks remotely like a concerted effort to reflate prices.
It’s no wonder that markets don’t like it. This is their great protector, suddenly impotent. So long as the Fed remains bound between the poles of low inflation targeting and reflation, the signal that the markets will act upon is the increasingly obvious impotence. That will eventually break the impasse, through falling markets.
