US: What's Needed To Trigger The Fed?

  Don't Rule Out Further Easing - But Things Have To Get Ugly First

The current Operation Twist is scheduled to be terminated at the end of June, which renders the 20 June FOMC meeting an obvious candidate for QE3. The chance of this happening has risen lately following the weak PMIs out of Europe and the slowdown in Chinese growth, which seems to be hurting the US manufacturing sector. On top of this, minutes from the April FOMC meeting were slightly more dovish, as the number of members indicating that “additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became
great enough” rose to “several” from “a couple”.

That said, as stated in the minutes, the FOMC needs to see a loss of momentum in growth in order to support more QE and this has not materialized in domestic data so far. This was also confirmed by comments from Dudley, the President of the New York Fed, yesterday. Over the past couple of months US data have been mixed but generally point to a continued moderate recovery (see Research US: Don't write off the US economy, 22 May 2012).

Labour Markets

Fed’s primary focus is the state of the labour market and the May employment report released on 1 June will be key. The March and April reports showed a deceleration in job growth and if this continues, the pace of employment growth will be below what the Fed sees as consistent with its mandate. If we get another weak employment report, it would,
in our view, tilt the balance in favor of another round of QE. This is however not our expectation, as other indicators such as initial jobless claims and the NFIB survey are pointing to a continued healing of the labour market.

Another trigger of QE3 is financial stress. Although the European crisis has pushed market stress upwards, we are still far from the levels seen in H2 last year. Also worth keeping in mind is the reasoning behind the decision about QE2 in September last year. The FOMC minutes show that the primary reason for the decision to implement Operation Twist was the deterioration in economic growth momentum and not the stress in financial markets. We thus think that stress levels need to go markedly higher before the Fed will act, as long as economic data continue to confirm an ongoing economic upswing.

Sterilized Bond Buying a Strong QE3 Candidate

Given our expectations of a rebound in private job growth in May, we currently see only a 25% chance of further Fed easing at the 20 June meeting. However (if we are proven wrong), there was an interesting article in WSJ in March, describing possible tools for further monetary policy easing. If another round of easing is deemed necessary, it is likely to be in the form of sterilized bond buying, i.e. the Fed buys longer-dated MBS or Treasuries and withdraws the extra liquidity generated by this transaction via reverse repos or term deposits. This would favor those in the FOMC who worry about the inflationary effect of the expansion of Fed’s balance sheet and increase in the money base.

 Asad Khan
Financial Analyst  (CFB)
050-8774861
asad@cfb.ae