US to launch second wave of quantative easing

The potential for policy shifts in the US economy has been the pivotal driver in financial markets ever since Fed member Bullard surprised investors early in the summer by floating the prospect of the printing presses rolling again. After what has seemed an eternity, the US Federal reserve confirmed last night that they will launch a second wave of quantitative easing; the so-called QE2.

In the official statement following last night’s FOMC meeting, the Fed observed that “the pace recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in non-residential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.” In short, if official interest rates weren’t already on the floor then the Fed would be cutting them. Without the freedom to cut rates, the Fed intends to purchase an additional $600bn of longer-term Treasury securities by June 2011, a pace of about $75bn per month. [According to Fed data, these purchases should bring overall Fed holdings of securities to $2.6 trillion.]

The act of QE is to induce – through price – holders of securities to trade them in for cash. The hope is that those holders use that cash to go and buy things. Clearly the reality perceived by the Fed is that too much of that cash is being hoarded. [It is worth noting in passing that QE can also be used defensively by acting to ensure that rising market yields don’t stunt any nascent revival.]

For those sceptical of the need for action, the Fed “continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.” It was also interesting to note the number of times that the Fed remarked that its actions are consistent with its mandate; perhaps they fear accusations of being far too free and easy with monetary policy – they are clearly ‘twitchy’.

The sceptics base much of their concern on the failure of many headline economic and sentiment indicators to sustain the setback  evident in Q3. This recovery of poise is perhaps best illustrated in Figure 1 below. The figure plots the relationship between the main US business indicator of employment intentions and the change in the unemployment rate over the year ahead. Part of the Fed’s mandate is to maintain full employment. Figure 1 implies that a meaningful retreat from the current unemployment rate of 9.6% is on the cards.

Figure 1: Employment intentions vs change in unemployment rate (YoY, %)

Regardless, the US Fed have chosen to act to ensure that inflation moves further away from the deflation danger-zone. Doubtless they will have felt encouraged by the prospect of political stalemate following yesterday’s mid-term elections. If there is ‘heavy-lifting’ to be done, no one now expects the Government to do it. Perhaps as a result, the scale of the purchase programme is slightly above the apparent market consensus. This might have been thought to be supportive of the bond market however the buy-ins are being heavily targeted at medium term bonds rather than at the longer end; the yield curve steepened after the news. Actual implementation of QE2 will be subject to ongoing review and with the voting membership of the FOMC set to become more hawkish – with new members coming on board – signals that the ‘forecast’ in Figure 1 is proving accurate will doubtless lead to sharp bouts of angst in the bond market.

The US$ may well now still remain soft of policy grounds however that could change quite sharply as and when investors bring their gaze back onto Europe; highly likely given that the Fed ‘game’ is over. With this in mind the recent rise in peripheral European sovereign credit default rates will acquire more importance. A soft $ and a steepening yield curve should ensure that Gold remains sought after. The lemming-like rush into all things EM will not be checked by tonight’s announcement. Finally equities are well placed despite having enjoyed an Indian Summer. Policy is unequivocally supportive, earnings are fine and investors sceptical.

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