n Shakespeare’s Hamlet, the protagonist opens with a soliloquy that compels the audience to ponder two forms of existence: whether to be passive and accept things as they are, or to be active and fight against them. Which is better? The answer is a personal choice that depends greatly on one’s judgment of the potential benefits and the costs of the battle. As Hamlet put it, one must ask whether it is better to “suffer the slings and arrows,” or “take arms against a sea of troubles,” even when the cost of doing so may be high: death, in Hamlet’s case.
Like Hamlet, Federal Reserve Chairman Ben Bernanke faces a choice; whether to “QE or not to QE,” which is to say whether or not to conduct a third round of Treasury, agency and/or mortgage-backed securities purchases in order to fend off the ravages of the deleveraging process. In other words, whether the Fed should conduct QE3 – a third round of quantitative easing.
Bernanke, thankfully, needn’t worry that the cost of his decision will be as fateful as Hamlet’s. Nevertheless, the decision on whether to conduct QE3 and thus provide additional fuel to reflate financial assets will be consequential, because the decisions rendered by the Federal Reserve affect millions of people, not only in the United States but throughout the world.
Doing nothing could disrobe the recent rally in risk assets and reveal it for what many believe it is, which is an unsustainable rally that will last only if ever more monetary stimulus is injected into the veins of global investors by the Federal Reserve and the rest of the world’s central banks. By this view, absent more “monetary morphine,” investors will focus more intensely on the troublesome debt burdens of the developed world. Therefore, if the Fed does nothing, asset prices could fall and thereby threaten America’s fragile economic recovery, which is built in part on rising asset prices and its attendant wealth effects.
If, on the other hand, the Fed decides to again take up arms to battle the forces of deleveraging, it could fall onto its dagger, committing a classic error in central banking by acting during a turning point and thereby doing too much, with the costs outweighing the benefits. In particular, if the Fed provides further monetary stimulus it could result in too much “bad inflation” and too little “good inflation” by boosting inflation expectations more than desirable without resulting in any meaningful gain in asset prices.
When Op-Twist ends, Treasuries will lose a big buyer
The question of whether “to QE or not to QE” will be very important to investors in the second quarter because at the end of June the Federal Reserve will be completing Operation Twist, which is designed to lower longer-term interest rates. In Operation Twist, which began last November, the Fed is selling $400 billion of its holdings in Treasury securities maturing in three years or less and simultaneously purchasing Treasury securities maturing as long as 30 years out. During the operation, the Fed will absorb the equivalent of all of the issuance of U.S. Treasury securities maturing beyond seven years, although not directly because the Fed’s purchases occur in the secondary market. When Operation Twist ends, global investors will be left to shoulder the burden.
QE quelled for now, but perhaps not for long
To answer the question on whether a third round of QE is necessary or not, the Fed will consider whether it is meeting its objectives on both sides of its dual mandate: employment and inflation. Recent developments for each are likely to forestall any immediate decision on QE3.
Progress has been made, for example, on the employment front, with the six-month moving average for private payroll gains increasing to 214,000 per month in the six months ended in February 2012 from 160,000 per month in the 12 months prior. Importantly, weekly filings for initial jobless claims have fallen to a four-year low, fully 100k below year-ago levels and in territory consistent with a further decline in the unemployment rate (see Figure 1). To be sure, some of the recent progress on employment almost certainly relates to the relatively warm winter in the U.S., but the Fed won’t be able to quantify the impact for a few months.
The recent acceleration in labor demand has been accompanied by a strengthening of economic activity in other areas of the economy, including residential construction, automobile sales, industrial output, consumer credit, business lending and capital spending. Gains in financial assets are supportive of each of these, but as mentioned the gains themselves are a product of the Fed’s accommodative stance on monetary policy.
The sustainability of the recent strengthening of economic activity is threatened by a number of ongoing and upcoming factors:
- An unwinding of the inventory buildup in the fourth quarter of last year
- Payback from economic strength in the warm winter weather that borrowed from future months
- Wealth destruction: $8 trillion of lost household wealth has yet to be recouped
- A lack of mortgage credit availability
- Slow income growth: wages are gaining at a 2% pace rather than the normal 3% pace
- A massive fiscal cliff: over $500 billion of tax increases and spending cuts slated for January 1st
- Uncertainty over the U.S. election
- Slower global growth, particularly in (but not confined to) Europe
These factors seem compelling enough to warrant QE3, but the Fed will probably want to see how the economy evolves before tossing out recent data, especially with inflation expectations having increased.
To wit, inflation expectations have moved into territory that helps answer our pressing question about QE3. For example, Figure 2 shows the five-year/five-year forward breakeven rate, which estimates where investors believe inflation expectations will be in five years for the following five years. The five-year/five-year rate is a top gauge of inflation expectations at the Federal Reserve and provides a means of looking beyond near-term movements in the price of energy, food and other commodities to capture longer-term views on inflation that are often difficult to discern by other indicators, including the breakeven rate on inflation-protected securities.
As Figure 2 shows, inflation expectations are currently well above where they were when the Fed conducted its first two rounds of quantitative easing, both of which caused inflation expectations to increase. A third round of quantitative easing would be expected to do the same and therefore push inflation expectations to undesirable levels, given their higher starting point this time around.
So, what is the answer to the fateful question of whether to QE or not to QE? After great contemplation, the Fed will likely conclude that while the sea of troubles for the U.S. economy is big enough to again take arms against them, the combination of stronger economic data and rebounding inflation expectations makes it more likely that the Fed will hint at rather than decide on QE3 when it meets again on April 25th. The evolution of economic data and financial conditions will determine whether the Fed will act at its subsequent meeting on June 20th, but Bernanke has proven he is a man disposed to battle and is anything but stoically passive to all that troubles the U.S. economy.