Evaluation Of QE2 And Preview Of Possible QE3 Ahead Of Jackson Hole Symposium

The next major event in the US after the August FOMC meeting will be next Friday's economic policy symposium in Jackson Hole, Wyoming. After the Fed announced to keep interest rates at exceptionally low levels at least through mid-2013 on August 9, the market has been increasingly speculating that Chairman Ben Bernanke will signal additional easing measures at the meeting next week. According to a CNBC survey done after the FOMC meeting, 46% of respondents said the Fed will resume QE, up from 19% in the July survey while 37% said the Fed will not do QE, down from 68% in July. Also, of those who believe the Fed will resume QE, the asset purchases are expected to average at 628B, up from 377B in July.

While market sentiment has been lifted by the speculations with the Wall Street paring losses and the US dollar weakening, the actual impact of new asset purchases, i.e. QE3, remains uncertain. It's even possible that the new program fails to stimulate the economy. Let's take a look at the economic and financial market developments between the period after Bernanke hinted about QE2, the 600B bond purchase program, at last year's Jackson Hole speech and the end of the program June 2011.

GDP growth eased for 3 more quarters (from 3Q10 to 1Q11) after the speech on august 27, 2010 before recovering softly to +1.28% in 2Q11. Unemployment rate continued to climb higher until reaching 9.8% in November 2010. The rate then began its 4-month fall to 8.8% in March 2011 before rising above 9% again. It's apparent that the 600B asset-purchase program did not satisfactorily boosted growth and employment. Liquidity injection did boost inflation with the headline CPI surging to 3.4% y/y in June from around +1.2% before the Chairman's speech.

Concerning financial markets, Wall Street was bolstered with each of DJIA and S&P 500 Index rising more than +20% during the period. The gains were, however, pared over the past weeks. The commodity index also jumped +20% but the ICE US dollar Index plummeted -10%. Among the assets, silver rose the most, surging +82%, and was followed by oil and copper. Obviously, much of the injected liquidity was fled to commodities with rising inflation as a result.

As stated in the August FOMC statement, the Committee discussed ‘the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate'. We believe the options the Fed has considered, after changing the statement language, include: lowering interest rates paid on excess reserve, shifting the composition of the balance sheet to longer maturity, formalizing an inflation target, indicating explicit interest rate ceilings for longer-term Treasury debts (with an ingredient of asset buying) and outright bond purchases (i.e. QE3).

If the Fed chooses to go further down to easing, we expect it needs to deliver something more than just pledging to keep the balance sheet large or lowering interest rates paid on excess reserve. Chairman Bernanke may have to signal an expansion of asset buying in order to bolster market sentiment. During the first 2 QE programs, the Fed had injected 1.75 trillion and 600B respectively to the market. It's estimated that the central bank had pushed down the 10-year Treasury yields by 25-50 bps per 1 trillion of asset bought during the previous 2 moves. Therefore, we expect the size of asset purchase will be similar in the case of QE3.

The Fed may choose to shift the composition of the balance sheet to longer maturity instead of expanding the size at the current stage. By achieving this, the Fed may increase the average maturity of the reinvestment the MBS proceeds or sell its 279B of Treasury notes and bonds with maturity before the end of June 2013 and buy long-duration securities with the proceeds. It may also consider buying mortgage-backed securities which currently have duration of 6-7 years.

The move to additional quantitative easing is not free from criticism. It's obvious that the 3 dissenters at the August meeting will reject asset purchases or changes in the balance sheet composition. Philly Fed President Plosser said earlier this week that the announcement of keeping the Fed funds rate at exceptionally low levels at least until mid -2013 was an 'inappropriate policy at an inappropriate time'. He is concerned that inflation will accelerate in 2012 and 2013. Both he and Dallas Fed Fisher said that the easing measures should not be used to boost the stock market. Fisher said the central bank should 'never enact such asymmetric policies to protect stock market traders and investors'. Potential stimulus from the Fed also triggered criticism from Republicans. Texas Governor Rick Perry said any move by Bernanke to act on stimulus measures before the 2012 election would be 'almost treasonous'. While the Fed pledged its independence to politics, the 'threatening' language inevitably raises hurdles for the Fed to move further to the path of easing.

What Does Bernanke Want to Tell Us At Jackson Hole?

As the annual Jackson Hole Symposium approaches, there have been talks in recent days that Fed Chairman Ben Bernanke will probably disappoint the market, i.e. he will not hint about additional easing. Look at yesterday's price movements: the advance in the USD, the sharp decline in US Treasury and the selloff in gold, it suggests that investors are reducing their speculations on QE3 in August. The title of Bernanke's speech this year is 'Near and Long-Term Prospects for the US Economy', compared with last year's 'The Economic Outlook and Monetary Policy'. Some market participants said the Chairman omitted 'monetary policy' as he wants to tune down hopes of further policy action.

We expect Bernanke's speech will focus on 1) US economic outlook; 2) review of policy actions and 3) discussion of policy tools. As indicated in the August policy statement, policymakers viewed that growth has been 'considerably slower' than expected. Temporary factors including 'higher food and energy prices' and 'supply chain disruptions' associated with the earthquake in Japan' accounted for 'only some of the recent weakness in economic activity', suggesting the slowdown has been driven by more pervasive factors. The recovery will take place at a 'slower pace' with increasing downside risks in the economic outlook over coming quarters and the unemployment rate will 'decline only gradually' toward levels consistent with the Committee's mandate.. While revising down the economic outlook, policymakers were not completely pessimistic. New York Fed President William Dudley said last week that US data were 'at worst, mixed'. Banks are 'in much better shape' with 'huge liquidity buffers compared to where they were in 2008'. He expected that there would be 'stronger growth in the second half'. Cleveland Fed President Pianalto, who has never dissented from an FOMC decision, said she forecast US' GDP will grow 'at a rate of about 2% this year, and about 3% in each of the next 2 years'. The Chairman will probably elaborate more about the central bank's view on the growth prospect.

As we showed in the article titled 'Evaluation of QE2 and Preview of Possible QE3 Ahead of Jackson Hole Symposium', the impacts of QE2 on bolstering economic growth were not significant. Inflationary pressures were, however, lifted after liquidity injection. The situation should have triggered questions about effectiveness of easing measures. We expect the Chairman to address the issue at the conference. At the same occasion last year, the Chairman stated central bankers 'alone cannot solve the world's economic problems'. He will probably reiterate similar stance this year.

The August FOMC statement unveiled that the Committee had discussed 'the range of policy tools available to promote a stronger economic recovery in a context of price stability'. In our opinion, Fed's remaining options include lowering interest rates paid on excess reserve, shifting the composition of the balance sheet to longer maturity, formalizing an inflation target, indicating explicit interest rate ceilings for longer-term Treasury debts (with an ingredient of asset buying) and outright bond purchases (i.e. QE3). While it may not be announced at the conference, the Fed should be in favor of changing the composition of the balance sheet and outright bond purchases.

Rising inflation and a more-divided Fed may have complicated policymakers' monetary decision. However, we believe the 3 dissenters will unlikely hinder the Fed from implementing additional easing measures they are deemed necessary. The single most important factor is still economic developments, i.e. whether employment and inflation are at levels that are consistent with the Fed's dual mandate.