The two-day FOMC meeting ended largely as expected, with the Fed reaffirming the current policy stance. If you were looking for signs that QE3 is on the horizon, you were sorely disappointed. If anything, the FOMC statement shifted in a slightly hawkish direction, setting the stage for the next policy move to be a tightening. The Fed is trying to make it as straightforward as possible – in the absence of clear and convincing evidence that deflation is again a threat, they have nothing else to offer.
The statement itself made clear the Fed interprets much of the current data flow as reflecting temporary factors, either the impact of higher commodity prices or the disaster in Japan. Interestingly, though, temporary factors alone are not sufficient to explain the slowdown, as the 2012 GDP forecast was downgraded. Federal Reserve Chairman Ben Bernanke admitted this during his subsequent press conference. In response to a request for the forecast he brought to the meeting, he suggested that he was on the low side of expectations:
[The] “slowdown is at least partly temporary….can’t explain the entire slowdown…Growth at least in the near term might be a little bit less than we anticipate.”
Still, despite the slowdown, the Fed removed the “employ its policy tools as necessary to support the economic recovery” language, presumably because they have no intention of providing any additional support. Moreover, inflation trends are no longer “subdued.” Instead, they see a “subdued outlook for inflation,” another signal that they are not thinking about easing, but instead restraining themselves from tightening now.
As Mark Thoma notes, Bernanke made clear that the shift away from deflation concerns effectively ends the possibility of another dose of quantitative easing. So what happened to the Bernanke of a decade ago, when he chastised the Bank of Japan for inaction? Brad DeLong laments:
Those of us Democrats who were happy when Barack Obama reappointed Ben Bernanke as Fed Chair thought that we were getting the Ben Bernanke we knew--the student of the Great Depression and of Japan's Lost Decade dedicated to doing whatever was necessary to stabilize the time path of nominal GDP, up to and including dropping bales of money out of helicopters.
Whatever happened to him?
My first thought is that we forgot or overlooked the fact that Bernanke is a child of the Bush Administration, which should have been a red flag that he was not all that he was thought to be. My second thought is that I don’t see Bernanke as terribly out of line with the current Administration itself. Third, Bernanke made clear in his response to a Japanese reporter that he sees himself as exactly the Bernanke of a decade ago. His comments then meant that:
“…a determined central bank can always do something about deflation.”
Like inflation, deflation is a monetary phenomenon, and, as such is within the control of the monetary authority. He acted on that belief last fall with the Fed’s second large-scale asset program – a policy that had more to do with eliminating deflationary expectations than the path of growth. Those deflationary concerns have now been replaced by the more traditional inflationary concerns. To be sure, the growth forecast leaves much to be desired, and the unemployment outlook should arguably be seen as a crisis. But – and I think this is key – the Fed believes that they have little traction over growth at this juncture. Thus, additional policy yields no improvement on the employment outlook, but potentially adds to an already uncomfortable inflation tradeoff.
Simply put, from the Fed’s point of view, the balance of risks is clear. And that means we should expect nothing more from Constitution Ave.
Despite the clear direction from Bernanke, Bill Gross of PIMCO doubled-down on his failed bet that this statement would hint at QE3. Via Reuters:
Gross, the co-chief investment officer of PIMCO, the world's top bond manager, on Wednesday said on Twitter: "Next Jackson Hole in August will likely hint at QE3 / interest rate caps."
Consider the timeline. Today, the FOMC and Bernanke himself only further distanced themselves from another dose of easing in this cycle. That means he need a full 180 degree turn by August, less than two months away. Consider too that we would need a deflation threat to create such a turnaround. But, even if commodity prices stabilize, or even decline, the pass-through from previous price increases is still likely to be working its way through the core data. And it defies belief that, given the current attitude among FOMC members, they would entertain the thought of deflation with such inflationary pressure in the pipeline, even if you believe it to be temporary pressure.
Moreover, any commodity price declines are likely to provide a boost to growth. Moreover, so too will an easing of Japanese related supply issues. Which means a reasonable chance that growth looks stronger in comparison to recent weakness. Not terrific, mind you, but the level is unimportant. What is important is simply that growth does not deteriorate, and instead improves, however modestly.
All of this argues against Gross’s outlook. Which means you need a vastly contrarian actual outcome, and it needs to fall into place quickly. That outcome, as far as I can see, is some combination of a shift to deflation concerns, a dramatic downward shift in the 2012 growth forecasts, or massive financial contagion from the European crisis (best guess on this is that Europe kicks this can down the road for a few months anyway).
Which, in sum, means to need to ask yourself this question if you are going to jump into the Bill Gross camp: “Do you feel lucky, punk?” It seems like an awful lot needs to go wrong in the next few weeks to get QE3 at Jackson Hole. I am not saying that it can’t go wrong, and if it does I will happily give credit to Gross for his wisdom and insight. That said, the time horizon is remarkably short, and will shrink rapidly, to generate the kind of change of heart at the Fed necessary to prod officials into another round of easing. It would seem that financial crisis is the only event that could prompt such a shift in just two months.
Bottom Line: The Fed believes they are done easing, and policymakers now look toward tightening. I know, I know – they have said this before, which is reason enough to take their tough talk with a grain of salt. But the shift in the inflation outlook looks very much to represent the high water mark for policy. The data will need to dramatically deteriorate to shift the Fed’s focus away from tightening.