Goldman Sachs on QE2

Dissension in the FOMC Sets a High Hurdle for QE2 in the Near Term

An article in today’s Wall Street Journal  reveals a deep split within the Federal Open Market Committee (FOMC), with no fewer than seven (of 17) participants at the August 10 meeting voicing reservations about the decision ultimately taken to reinvest repayments of principal of agency debt and mortgage-backed securities.  So the decision was indeed a much closer call than suggested by the ultimate 9-1 vote of the 10-member voting rotation.

The article has two implications for the near term.  First, Chairman Bernanke’s speech on Friday, opening the annual Jackson Hole symposium, is apt to be more backward-looking than it might otherwise have been.  Second, the hurdle for further easing at the September 21 FOMC meeting is quite high, as many FOMC members are clearly not ready to embrace such a move.
Ultimately, however, we continue to expect that QE2 will be forthcoming later this year or early next year, as slow growth and rising unemployment raise concerns about a potential double dip.
Today’s edition of the Wall Street Journal (WSJ) contains a remarkable article by Jon Hilsenrath on the split of opinion within the Federal Open Market Committee (FOMC).  According to Mr. Hilsenrath, no fewer than seven “participants” at the August 10 FOMC meeting voiced reservations about the decision ultimately taken to reinvest repayments of principal on agency debt and agency-sponsored mortgage-backed securities (MBS) now being held by the central bank.  (In FOMC lingo, a committee “member” is one who can vote at that meeting; “participants” include all governors and regional bank presidents, a list that currently numbers 17 given the two vacancies that remain unfilled on the Board of Governors.)

The remarkable aspect of this article is its identification of numerous individuals on both sides of the debate about whether to take this step.  Spearheading the argument to act, according to Mr. Hilsenrath: Presidents Dudley (New York), Rosengren (Boston), and Yellen (San Francisco).  Beyond its ongoing concern that the FOMC’s ultimate goals of “maximum employment” and inflation between 1½% and 2% seemed out of reach, this group was increasingly worried that faster-than-expected refinancing of mortgages underlying the Fed’s vast portfolio of MBS would cause its balance sheet to shrink almost twice as fast as had been estimated as recently as March.  In essence, the implicit modest tightening implied by the policy not to reinvest these proceeds was turning out to be a larger than previously thought.  On the other side, the list of those expressing reservations included (again per Mr. Hilsenrath): Presidents Richard Fisher (Dallas), Narayana Kocherlakota (Minneapolis), Jeffrey Lacker (Richmond), and Charles Plosser (Philadelphia), and Washington-based Governors Elizabeth Duke and Kevin Warsh in addition to Thomas Hoenig, the president of the Kansas City Federal Reserve Bank who has dissented consistently through the first five meetings of the year.

As we already knew from the policy statement released just after the meeting, the 10 members currently voting on the FOMC ultimately approved the reinvestment decision by a 9-1 vote, as Governors Duke and Warsh voted with the majority despite their concerns.  But the article confirms that the decision was a much closer call than implied by this near-unanimous result, as we had thought it would be in the days leading up to it.  This is the just latest example of an aspect of FOMC decision-making that has long been apparent: the hurdle for dissent by a governor is higher than for a regional president.  The last time a governor dissented was in September 2005, when Governor Mark Olson objected to a 25-basis-point rate hike a few weeks after Hurricane Katrina created uncertainty about the economic outlook.

In terms of implications for events in the days and weeks immediately ahead, we draw two conclusions from this article:

1.     Chairman Bernanke’s speech on Friday will be more backward-looking than it might otherwise have been.  As is customary, the chairman will open the annual Kansas City Fed symposium at Jackson Hole, Wyoming, this Friday at 10:00 am EDT.  For some time, the Fed’s website has listed the title as “The Economic Outlook and the Federal Reserve’s Policy Response,” a topic that would lend itself nicely to sketching out the broad parameters of what it might take to elicit another step from the FOMC to support economic growth.  However, the FOMC is far from any consensus on this matter; moreover, the reported split is now a matter of public record.  Under these circumstances, it would be premature for Chairman Bernanke to provide a set of guideposts for future policy moves, as helpful as that would be for the markets and as much as we believe that additional easing will ultimately be needed.  Instead, we expect him to concentrate on how the economy and the Fed have come to where they are now, with at best just a general sense of economic risks in the months ahead.

2.     The hurdle for renewed unconventional easing is quite high for the September 21 FOMC meeting.  Two aspects of the WSJ article suggest this.  First, in a one-day meeting the committee did not have time to discuss any of the options Chairman Bernanke mentioned at the monetary policy hearings in mid-July when asked what the FOMC could do to help bolster growth.  His list included: (a) strengthening the commitment to keep the federal funds rate low, (b) reducing the interest rate now being paid on excess reserves (IOER), and/or (c) initiating a new program of asset purchases.  Second, the resistance to the more limited option of reinvesting principal repayments was evidently significant despite the fact that this merely removed a tightening bias in the existing policy stance.  This tightening bias would have been very significant, as New York Fed’s Open Market Desk had in the run-up to the meeting sharply increased its estimates of how much MBS principal would be paid down over the next year under an unchanged reinvestment policy.  We conclude from these points that many FOMC participants are far from ready to embrace new easing steps.

In combination, these two points imply that quite a bit has to happen, both in terms of further deterioration of the economic data and discussion within the committee, before additional decisions are taken.  Note in this regard that the September meeting is another one-day affair; unless the meeting is extended to two days, it will probably be difficult to pull together a consensus by the end of that session.  Thus, whereas we previously were tempted to think that any significant disappointment in the employment report (e.g., shrinkage in nonfarm payrolls) might elicit further action in September, it now appears that downside surprises in the data—however and wherever they show up—would have to be quite large.  Otherwise the committee will be inclined to wait until at least the November 2-3 meeting, when it has more time to deliberate and will also be revising its formal forecasts for growth and inflation following publication of the government’s preliminary estimate of growth in the current quarter.

Over time, however, we continue to expect sluggish growth, rising unemployment, and further reductions in an already low inflation rate to prompt a new round of unconventional easing, widely known as QE2.  The behavior of the unemployment rate will be especially important, as this provides the best summary of how the risks of renewed recession are evolving.  As we have noted many times in the past, whenever the 3-month average of the jobless rate has risen more than 0.3 percentage points from a newly established trough, the US economy has either just entered an NBER-designated recession or been on the threshold of one.  This rule has a perfect 11-for-11 record in the post World War II era.  However, it was never tested during the “jobless” recovery phases of the last two business expansions, when the unemployment rate continued to rise instead of edging down, as it has in this one.  While it is conceivable that the rule might not work this time, Fed officials will not want to wait to find out.  Thus, we expect renewed monetary easing as the unemployment rate approaches 10%, later in 2010 or early in 2011.