Will the US Federal Reserve end its asset purchases (QE2) early? Or give us QE3? And will the Bank of England raise interest-rates?

At the end of last week we saw the European Central Bank take centre stage with its threat/promise to raise Euro zone official interest-rates at their April meeting. If you translate their code then you would now think that a rise in April from the current 1% to 1.25% was now more likely than not, although in the current volatile environment (North Africa for example) there is no such thing as certainty. One thing that the “shock” effect of their announcement did remind me of was the tactics of the German Bundesbank which loved to do the unexpected and shock markets in the 1980s and 90s. They always had you on your toes. I suspect this tactic may well be related to the current Bundesbank President Axel Weber announcing he will not stand to be the next ECB President with the ECB Governing Council feeling its credentials need a boost as the standing down of “Darth” Weber had sent the reverse message. This led to the following question in my mind.

What will the other central banks do?

As China is involved in tightening anyway there is little change for her. Japan is still mired in disinflation so again little likely change. Indeed from the point of view of Japan the rally in the Euro exchange rate which this statement produced is likely to be welcome and frankly they would like more of it! As Japan has an overvalued currency and has exporters struggling with its inflated level the Bank of Japan will welcome this new policy and an exchange rate of 115 Yen to the Euro. So in spite of their own monetary policy still being very loose and in fact pretty much the opposite of what the ECB proposes it may well raise a smile in Tokyo.

The US Federal Reserve

Here we find another central bank with a loose monetary policy. With interest-rates set in a range of 0 to 0.25% and asset purchases planned of US $75 billion per month ( until June 2011) policy could hardly be much more expansionary. Will it now change? The last 24 hours have seen 2 voting members of the Fed give speeches and one be interviewed on CNBC. As the debate starts with will QE2 (the asset purchases) now end early let us start with the most “hawkish” of the three Richard Evans of the Dallas Fed.

Richard Evans: President of the Dallas Fed

Mr.Evans first lets us know his view on the current policy known as QE2

There are some, including me, who argued against the last tranche of insurance we took out in committing to buy $600 billion in U.S. Treasuries between last November and the end of this coming June as we were simultaneously purchasing additional Treasuries to make up for the roll off in our mortgage-backed securities.

Okay Richard why do you think that?

There was a strong feeling among those of my policy persuasion that we had already sufficiently refilled the tanks holding the financial fuel businesses needed to drive their job-creating machines. They felt that by being too accommodative, we might run the risk of planting the seeds that could germinate into renewed volatility, speculation and inflation, or give comfort to a government that for far too many congressional cycles has fallen down on the job by spending and borrowing and committing to unfunded programs with reckless abandon.

Indeed he goes onto tell us this.

I do not, however, feel that further monetary accommodation will speed the process. It might well retard job creation, should it give rise to inflationary expectations or, worse, imply that,……. we have now been compromised and become a pliant accomplice to Congress’ and the executive branch’s fiscal misfeasance.

Comment

If you combine this speech with previous ones by Richard Evans it is plain that he is no fan of what is called QE2. However I see no sign in the speech of any hint that he will vote to stop it. Indeed rather oddly he actually voted in favour of it at the last FOMC meeting! Quite how he managed that feat of intellectual gymnastics I am still not quite sure but he did. Indeed he even mentions the factor that to my mind means that QE2 and QE-lite are likely to continue until they expire.

But it is worrisomely clear that the task of putting millions of unemployed and underemployed Americans back to work will take an anguishing amount of time.

Members of the FOMC are referring to this fact so often these days it makes me wonder more and more what will happen when QE2 and QE-lite end in June. If we saw the picture for unemployment and employment deteriorate there is little doubt in my mind that the FOMC would then vote for a new round of asset purchases which would no doubt be called QE3. As I expect asset purchases to suffer from the law of diminishing marginal returns there would then be serious problems as QE3’s very existence would already imply that QE,QE-lite and QE2 had not succeeded.

Just to be clear Richard Evans assures us that he would not vote for a QE3 but he previously said he was against QE2 and then voted in favour of its continuation. So here is my message to those who expect QE2 to end early. Who is going to vote for this if not Richard Evans? Of course circumstances may change but as we stand there is little sign of the improvement required.

Charles Evans: President of the Chicago Fed

Charles Evans who apparently likes to be called Charlie (sometimes you couldn’t make it up…..) was interviewed on and looking at the transcript and trying to make sense of what seem at times to be confused ramblings we get this.

That’s part of my rationale for why $600 is a good number for our asset purchase size. I– when we started this, I might have thought that, you know, $600 was a good start to the program and we might have to do more. It’s looking more and more to me that $600 is a good number for this.

I am giving him the benefit of the doubt and assuming he is aware that it is US $600 billion for QE2 rather than an amount some US $599.999994 billion smaller! However the message is clear to my mind, Charlie has only thought of more so far and not less.

Dennis Lockhart

In a speech which has now disappeared from the Atlanta Fed website President Lockhart told us this.

My first inclination is to be very cautious about extending asset purchases after June…………….Given the emergence of new risks, however, I prefer a posture of flexibility as regards policy options.

Comment

I think that the US Federal Reserve  is sending out a message that its polices are working well and that we can expect economic growth of 4% this year and 4% in 2012 too. Accordingly this makes people wonder if the current programme of asset purchases might end early. Personally I feel that the scenario presented is rather rose-tinted and that one factor will worry FOMC members. What if they turn of the QE2 and QE-lite taps and the stock market and asset prices immediately go into reverse? What do they do then? Well might they worry in my view.

If you take my suggestion then any dip in the economy makes a further round of asset purchases possible and then probable depending on the scale of the dip. As the FOMC talks more and more about unemployment it is my view that these figures as they develop in the spring and summer of 2011 will in effect be setting US monetary policy.

The UK and the Bank of England

Here we have a central bank with a clear inflation problem. The officially target inflation index for consumer prices or CPI is at 4% which is double its target and its predecessor RPI is at 5.1%. As the equivalent inflation rate in the Euro zone is only 2.4% it is clear that were the ECB to be in charge of UK economic policy we would already have seen not only a rise but rises in interest-rates.However the Bank of England is in what psychologists would call denial and its policy could be lampooned as “inflation I see no inflation” as like Nelson they put the telescope to their blind eye!

At the meeting on Thursday there is a chance that the Bank of England will raise interest-rates as at the last meeting 3 of the 9 members voted accordingly. So it would take only 2 more votes. As an aside I wonder if it could be 4-4 this time apart from the Governor who would presumably vote for no change. However I think that whilst possible it is still a low percentage chance.

Why?

1. The Monetary Policy Committee has often placed great store on economic growth figures. The latest official figures showed a fall of 0.6% in Gross Domestic Product or GDP for the last quarter of 2010.

2. More recent economic data does mostly show a return to growth but some elements have been weaker. For example we had estimates last week that whilst manufacturing was doing well the growth in services had slowed a little. Today we see that the British Retail Consortium  is reporting a drop in sales of 0.4% in February. So whilst the measures released are unreliable they may give an excuse not to raise interest-rates. We will get new figures for industrial and manufacturing output on the day of the decision so we will have to wait for them. some forecasters have been reducing their growth forecasts for 2011 presumably on the basis that 2010 ended weakly. (Personally I think that this is a mistake as we do not yet know with any clarity what did happen at the end of 2010 as there are many contradictory figures).

3. The Bank of England has invested a lot of its remaining authority and credibility in telling us that inflation is “temporary” and a result of “one-off” factors. Accordingly a policy change would be at best embarrassing….

A Wild Card

The wild card is that MPC members must be aware that they are attracting criticism which is rising and that their policy is becoming an ever larger embarrassment. Looked at like that then just like a wild animal which is cornered their behaviour is hard to predict and so I will be awaiting noon on Thursday!

A New Member of the MPC

If you were from Mars observing the UK over the period of the credit crunch you might think that it might be best to avoid appointing a banker at this time and that considering the company’s dodgy involvements around the world such as Greek debt derivatives it would be particularly wise to avoid appointing someone from Goldman Sachs.If you were willing to ignore that you might think that as ex-alumni of Harvard Business School were implementing policies which were under fire it might be best to avoid them too……… So I guess  our Martian is currently wondering about this appointment!

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22 thoughts on “Will the US Federal Reserve end its asset purchases (QE2) early? Or give us QE3? And will the Bank of England raise interest-rates?

  1. Hi Shaun,

    “1. The Monetary Policy Committee has often placed great store on economic growth figures. The latest official figures showed a fall of 0.6% in Gross Domestic Product or GDP for the last quarter of 2010.”

    I would agree that this has been very markedly so, but can you please explain where and when the MPC was ever given formal authority to use this as a basis to decide whether or not to take its only limited formally permitted action to control inflation? I have searched high and low through the regulations and remits and I have been unable to find any such authority having been granted to the MPC. Are you implying that the MPC is in fact acting illegally by using principally this issue to decide whether to take action to reduce UK inflation or not?

    • Well spotted, Drf. Under Gordon Brown’s Chancellorship the BoE was mandated with one and only one duty in this area: to maintain CPI at or near 2%.

      Merv & Co broadly followed this mandate by keeping interest rates far lower than they should have been in the years 2003-2007. This aided and abetted the credit and housing booms. But dear ol’ Merv had a get-out by reference to his BoE/MPC mandate.

      It is very clear that when Crash I happened Gordon Brown quietly abandoned BoE independence so he could dictate Int/Rate and QE policies to “save the world”.

      What we now see is the MPC operating under the broader (unofficial) new mandate by keeping Int/Rates at 0.5% to stimulate economic activity, but since the abandonment of BoE independence was unoffical, both Brown/Darling in their time and now Cameron/Osborne are referring to BoE independence as still being the current status. It most certainly is not.

      • Hi Bankrupt Taxpayer, I agree with the substance of your point, and that the base of the problem is a clandestine removal of any independence which the BoE and MPC originally had, but I think it is important not to confuse the role and remit of the BoE and the MPC; they are different. The BoE has a much wider remit. The MPC however, as far as I have been able to determine, has a much narrower formal remit, and as you correctly mention that is to control inflation in the form of CPI to 2%. Unfortunately though they were only ever granted one tool with authority to do this, and that was the authority to adjust BoE base rate.

        Since then as we all know, the MPC has somehow appropriated authority which it was never granted formally, nor any in fashion overtly declared by the government, Treasury, Exchequer, Chancellor, PM or Parliament, to take other actions to control not inflation, but neglecting inflation and instead attempting to control various other parameters of the UK economy, which normally should have been controlled not by the MPC but by the government in power, as part of fiscal policy. It would thus seem that if the MPC was never granted such powers formally it has been acting illegally, but no one in political or government office has ever queried this nor made any move to sanction its members’ offenses. That is why I was asking Shaun if he knew why this was and what the legal and formal position of the MPC actually is now.

        It could be as you infer that this is because governments have also been acting wrongly by condoning and benefiting from a situation which they know is illegal, because they feel if they get the MPC to do their dirty work there can be no repercussions upon them?

      • Drf below: I agree that Labour stacked the MPC with doves to some extent (with the obvious exception of Andrew Sentance!), but am I right in thinking that 5/9 members are from the BoE and 4/9 are external? Are you sure that the 5/9 that are BoE employees do not have one eye on ‘financial stability’ as well? (this is the last time I’ll say it, I promise)

        • Hi Graeme

          Yes you are right about the split which goes as follows.

          The Bank’s Monetary Policy Committee (MPC) is made up of nine members – the Governor, the two Deputy Governors, the Bank’s Chief Economist, the Executive Director for Markets and four external members appointed directly by the Chancellor. (You may also enjoy the next bit so here it is…..). The appointment of external members is designed to ensure that the MPC benefits from thinking and expertise in addition to that gained inside the Bank of England.

      • Hi graeme_b,

        My point was not concerning Brown’s original selection of those members of the MPC, which as we all know was extremely politically biased to ensure an intended outcome. I agree that the split between those members who already have internal responsibilities within the BoE and external members leads inevitably to conflicts; however for anyone who has a dual role in any similar situation, true professionals have to act within the specific remit and constraints for each role at the time, not mixing the divergent parameters. That means that any internal member must forget their normal role and remit when serving on the MPC, and must abide by the remit of the MPC only.

        I agree that part of the problem is that such internal members are not exercising those responsibilities conscientiously, but even that is not the point here. The point I was raising was that of legality. If the MPC has been given a legal responsibility only to control inflation, on the basis of only one control parameter, then for it to act on any other economic issue (particularly any which should in fact be the responsibility of the democratically elected government), or according to any other parameter as a control input, is not legally permitted action.

        I was thus asking Shaun, in the light of his point included today, what he understood was the width of the MPC’s formal remit and authority for action, and whether he was implying in his remarks that the MPC is in fact acting illegally by using principally an issue not included in their formal remit as the sole basis on which they are deciding whether to take action to reduce UK inflation or not by the use of the only tool which they have been permitted to use. So far it seems he is avoiding answering that question. I do not know whether that is because he does not in fact know the answer, or whether he just feels that the question is best avoided, as being too embarrassing or too dangerous?

        • Hi Drf
          I wasn’t avoiding the question, it was a busy day! As to sole measure for action I am not sure that is true and will double check the article to make sure I didn’t imply that. However I meant and stick by the view that it has been one of the main drivers of their interest-rates moves and timing and on quite a few occassions the main one… Accordingly as the last reading was -0.6 it makes a move tomorow less likely than otherwise.

      • Hi Shaun, to save you having to look back at what you wrote, I quoted it originally in my query: “1. The Monetary Policy Committee has often placed great store on economic growth figures. The latest official figures showed a fall of 0.6% in Gross Domestic Product or GDP for the last quarter of 2010.” You confirm the point again with “…it has been one of the main drivers of their interest-rates moves and timing and on quite a few occassions the main one… Accordingly as the last reading was -0.6 it makes a move tomorow less likely than otherwise.” This appears to confirm that the MPC is giving predominance to a control input which it was never given the formal authority to use in making a decision whether or not to control rising inflation, and ignoring inflation already above target and still rising?

        My point was that as far as I have been able to ascertain the MPC has never been given the formal authority to use that parameter as any input to whether they should attempt to control rising inflation. Their formal remit has always been a very simple one with only one parameter to address – inflation; not the state of the UK economy, not full employment, not the cost of government borrowing, not to prevent recession or depression. The latter formally are and always have been the responsibility of the elected UK government, as part of fiscal policy. My query was therefore, have the MPC been acting illegally in appropriating powers outside their official remit and in abusing the limited formal authority which they were originally granted?

        This issue is really similar to your previous point concerning the members of the MPC being democratically elected, since it would seem they have already illegally appropriated many of the powers in controlling the UK macro economy which were previously exercised by the democratically elected government, instead of sticking to their simple task of controlling inflaton.

        • Ah ok I am with you now!

          Along the way there have been those who think that the Bank of England is in fact targetting nominal Gross Domestic Product rather than inflation. If you take the logic of that it allows them to in effect try to fine-tune the economy with monetary policy and have an economic growth objective with the inflation objective. If we take that extreme case then clearly it is not the same as their mandate which is to hit a 2% Consumer Price Inflation target.

          Also if it is true that they are doing such a thing the recent surges in nominal GDP have proved they have been about as effective at this as they have been in controlling inflation! So ironically we come back to them making policy mistakes and not doing their job well. So whichever way it is argued it will presumably remain a secret amongst MPC members as to the reality but as David Byrne put it the result is “same as it ever was….”

          If you look at the employer of the man who has just been appointed to the Monetary Policy Committee as in the Vampire Squid (Goldman Sachs) I think my case for democratically electing the MPC has just received a boost. As a sign of intent it is hard to think of a worse one that could have been made.

      • Hi @notayesmanseconomics: Thanks for your kind words. Nice blog. I often hang out on The Slog blog run by John Ward and someone over there posted a link to your earlier article over here, hence my visit. Thankfully I am not bankrupt but that’s no thanks to the last government’s attempts to make me so!

        @DFR:
        I’m not sure if the MPC actions regarding the wider parameters being used to set interest rates are actually “illegal” or simply Merv & Co kowtowing to the government of the day. Over on the Slog, I have expressed the view that the old Bundesbank focused very narrowly on inflation for a long time very successfully and IMV the MPC should do the same.

        Also, one MPC member (Wheale?) recently responded to a question about the risk of stagflation if int/rates were raised with: “our role on the MPC is to focus on the inflation part of that. Growth is the responsibility of government.”
        That summed up my own view precisely and because of that I believe the MPC should be manned with inflation hawks, not inflation softies who fret about growth and other matters.

        rgds to all

  2. I think that the appointment to the MPC exemplifies much of what is wrong in this country.
    I believe that your Martian might be a little surprised to see Hector Sants in post. An investment banker by trade who failed utterly to see the credit crunch, who then failed utterly to see the extent of the capital damage on the banks (his report, quoted in the Telegraph yesterday, assumed that £20 bn would sort the whole thing out).
    The Martian might also be surprised at seeing Hester in charge of a major clearing bank. A former investment banker whose speciality was selling unsuitable bond issues to companies which then bought them back (Hillsdown, Tesco to name but two), with no clearing bank knowledge at all.
    If I were a cynic, I might start to think that this a closed club for those on the inside track. This cynicism would be made even more complete were I able to find examples of retired politicians now being employed by investment banks as a thank you for not regulating them in the first place (e.g. one T Blair).

    • Hi John
      Thanks for the comment and welcome to my part of the blogosphere.

      As to your point on longer-term interest-rates I write on them a lot and you might be shocked by what I think the new “normal” might be! With the issues over QE2,QE-lite and maybe QE3 I think that we are approaching something of a nexus…..

      • >>> As to your point on longer-term interest-rates I write on them a lot and you might be shocked by what I think the new “normal” might be! With the issues over QE2,QE-lite and maybe QE3 I think that we are approaching something of a nexus…. <<<

        I've yet to see any argument that could even begin to convince me that we're not in for a secular bear market in government bonds.

        As per Mckinsey's recent report, "Farewell to Cheap Capital"
        http://www.mckinsey.com/mgi/publications/farewell_cheap_capital/pdfs/MGI_Farewell_to_cheap_capital_full_report.pdf
        the development, urbanisation & industrialisation of frontier, emerging and progressing markets is likely to drive a major global investment boom, and thus a secular demand for investment capital.

        And the borrowing requirements of developed (deficit) nations represent another sustained long term demand for capital.

        Simultaneously, the demographic and other drivers of the so-called savings glut of the past couple of decades, which drove long term interest rates to all-time lows, are likely to diminish, be halted, or even reverse.

        Thus, combine a growing long-term global demand for capital with a restraints on its supply, and then throw the inflation genie into the mix*, and you have a potent brew for strongly rising long term interest rates.

        Shaun, I'd be very interested to hear your views on the path and ultimate destination for long term rates!

        * Courtesy of fundamental supply/demand imbalances for commodities as a result of global growth, combined with speculative safe-haven capital flows into commodities in response to QE debasement of currencies.

        • Hi Trevor
          I was going to respond that this is a subject that I have been discussing with a chartist – excuse me technical analyst- friend and ex-colleague of mine and say that I would ask for some new charts off him. However his opinions have arrived in my email inbox before I had the chance to ask! In the very short-term it looks like the pressure is on Italy so I have not much time to think through the position of the US except to say it in my opinion is near such a threshold too and that such a break would be major.

          Put another way in chartists terms the chart we were looking at was from 1977 aka a very large uptrend in prices and fall in yields which has lasted for 30 years or so. Our only debate was about timing….

        • Hi Trevor
          Let me reply again now I have some more time. I have been arguing on here for quite some time that we are approaching a turning point in longer-term interest-rates. If you look at where we have fallen from then in my opinion it would be quite likely that the rises could be measured in whole percentage points from here. If we look at the UK I remember long gilt yields being 15% in the late 80s and if you take our low as being 3% and ignore the percentage points then a reverse of only a third of the rally would take us back up to 7%….

          I have been discussing this with a friend who I worked with then and he has been a chartist since then and as we stand 30 year US bond yields are at a crucial level. He thinks that we could see some more range trading before we break higher in yield terms which is of course possible when you are looking at a period from 1977 to now on a chart even a few months is a blink of an eye.

          Should commodity and oil prices remain at these sort of levels then the resulting inflation is likely to make many bond yields look poor in real terms.

    • My opinion is good luck to them.

      However by the appointment of someone from Goldman Sachs and ex of Harvard Business School to the Monetary Policy Committee I am afraid the tentacles are tightenimg around us rather than loosening. They have I suppose given some grist to my campaign for our Monetary Policy Committee to be elected……..

  3. TRevor, I’m sorry but I’m unfamiliar with some of the terminology. If I catch your drift, Governments in emerging markets/countries are going to want to borrow more to fund development/infrastructure etc and the developed economies will still need to borrow to fund current expenditure.

    Meanwhile people will be saving less – and so the cost of borrowing is going to rise.

    If this is a fair reading, then doesn’t this raise the question whether the developed countries can afford to go on borrowing, and whether the developing ones will br able to raise the tax revenues to pay for the borrowing they need to develop?

    • Yes, governments and businesses in emerging markets will need to finance (through the bond and equity markets) their ongoing (and growing) intensive capital investment programmes, as they increasingly urbanise and industrialise over the years (decades) ahead. And over time, their populations, which currently have high savings rates, are likely to begin to save proportionally less so that they consume proportionally more.

      At the same time, developed deficit nations will continue to need to finance their deficits, and so will be competing for the same capital. Their populations may well begin to save proportionally more (and consume proportionally less) than they have, and this change has begun to take place already over the past 2 years, but this will have a fairly modest effect on the numbers.

      The upshot is likely to be a situation where the growing demand for capital is not matched by savings growing to the same extent. So, through the market mechanism, the price of that capital is likely to rise. Hence, the likely trajectory for long term interest rates (long bond yields) will be upwards.

      If you add inflationary impacts to this demand/supply imbalance for capital, you have the potential for very strongly rising bond yields (interest rates) over time.

      The impact of all this could be significant. In the US, for example, 30yr Bond Yields had been on a roughly falling trajectory since 1981, falling from around 15% to around 2.5% at the height of the banking crisis 2 years ago. This fall in yields underpinned all sort of investment trends, such as treasury, equity and property bull markets. An environment of long term rising interest rates, on the other hand, can be quite hostile to investors.

      May we live in interesting times!

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