Last week - before the most recent employment report - the Wall Street Journal offered up the odds of another round of quantitative easing:
“Primary dealers,” those 21 lucky banks that answered the Old Bridge Troll’s questions correctly and were granted the right to do business directly with the Fed, see QE3 coming and don’t see the Fed raising rates for at least two years.
That’s according to the results of a new survey of primary dealers by the New York Fed.
Primary dealers, on average, assign a 45% chance of a Fed interest-rate increase in the second quarter of 2014. Before that, the chances of a rate increase are never higher than 15%.
High expectations are not a surprise given the propensity of some officials to make remarks like these from New York Federal Reserve President William Dudley:
However, because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not.
It's no secret some Fed officials have been looking into additional purchases of mortgage-backed assets to support the economy via the housing market. And once they started talking about it, market participants began to assume it was imminent. Moreover, the idea of additional easing popped up in the most recent minutes:
A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework.
So now we have a timeline - first, enhanced communication. Second, additional easing. Seems straight forward, especially now that inflation looks to be trending downward, alleviating the panic that appeared to seize FOMC members in the first part of 2011.
But after the first part of 2011 comes a string of relatively solid data, at least as solid as one gets in this recovery. That data culminates with the decidedly not-terrible employment report. How long could it be before monetary policymakers started to question the need for additional easing?
Just a single day. On Saturday, St. Louis Federal Reserve President started to toss cold water on the idea of additional easing. Via MarketWatch:
“I don’t think it [QE] is very likely right now because the tone of the data has been very strong right now,” Bullard told reporters after a speech at the American Economic Association meeting....
...Bullard said he was encouraged by the December employment report that showed a drop in the unemployment rate to near a three-year low of 8.5%.
“I thought the jobs report was encouraging. Hopefully it is harbinger of more robust activity,” he said.
Bullard said he thinks Wall Street is too gloomy about the outlook.
“I think forecasters are a bit too pessimistic about the U.S. economy,” he said. “The recession has been over for fair amount of time. It is a logical point in the recovery where you would expect somewhat more rapid growth and somewhat better jobs market, so we’ll see if that is what happens.”
The logical point to see more rapid growth is in the quarters immediately following a significant contraction, not two years later. But putting that aside for the moment, I think it is easy for the Federal Reserve to read the recent data as signs the Great Depressing is beginning to unwind. Consider recent behavior of monthly private nonfarm payrolls:
Just eyeballing the chart, it looks like payroll growth is settling into a trend consistent with something around what we would think of as potential growth, except that growth may be a little slower than in the pre-recession period and is occurring along an equilibrium path below the pre-recession path. And that growth is translating into a falling unemployment rate:
At this rate, we could be approaching 7% by next year, which would then put unemployment below the Fed's forecast for 2014. By my standards still an unacceptably slow pace given that decelerating inflation provides room for additional easing, but I can easily see where FOMC members decided the risk of additional easing outweigh the benefits.
Now, in my mind, this would guarantee that the Fed would not be really unwinding the Great Depression as much as managing a the economy along a new trend. Unwinding the Great Depression, I think, means fully reversing the drop in the employment to population ratio:
Note that in the previous recession, the employment to population ratio edged up, but fell short of regaining the previous peak. Imagine the same occurring this time. Complicating a complete unwind is the economy's dependence on asset bubbles to support high levels of employment:
It seems that the loss of net wealth equal to 100% of GDP must be a depressing effect on spending. My sense is that we are unlikely to craft another widespread asset bubble and thus we will be missing a piece of demand that was critical to supporting the economy. How I think you might compensate for this lost demand is for the Fed to explicitly raise the inflation target and stimulate growth such that nominal wages rise sufficiently to quickly erode the real value of debt. If the Fed doesn't allow that to happen, instead sticking with the 2% target, then I suspect they will reduce accommodation long before the economy would regain the pre-recession equilibrium path. In other words, the Fed manages the economy along the new equilibrium path, and makes no pretense of trying to achieve pre-recession employment targets.
Could the Fed credibly commit to a higher inflation target and make actionable such a commitment? I think they can, but would need to announce they are making some permanent additions to the money stock and ease the expectation that the balance sheet expansion will be fully unwound at the first possible moment. In other words, to convince the public that you intend to raise the level of the price path relative to the existing path, you need to be willing to allow for the permanent increase in the money supply that would allow that to happen. Barring that, they can target the dollar directly and do what they won't do - buy foreign currency or foreign debt. But this is now a more academic than practical discussion. The Fed has a target. Period. End of story.
Bottom Line: Bullard reminds us that QE3 is not a certainty. True, inflation is easing and in aggregate the labor market remains weak, even if recent numbers are coming in a bit stronger. Arguably plenty of room for additional easing, which is why I have tended to think the Fed would eventually take additional action (that and the never-ending European mess). But the Fed hasn't shown an eagerness to ease further despite what they saw as a very slow reduction in unemployment - and it is reasonable to assume that forecast is getting a little bit brighter. Under such conditions, one or two months of "positive" employment news could fully derail the QE3 train. I increasingly think it depends on what the Fed's ultimate objective is - to unwind the Great Recession and attempt to restore pre-recession employment to population ratios, or just manage along a new output path. I used to think the former was the Fed's objective, but now am questioning that belief.
