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Through the Lens of FTN’s Economic Expectations

On September 1st, 2010, posted in: News by Pinnacle Bank

Bernanke is more optimistic than we are. The following is a synopsis of his speech. Through the lens of FTN’s economic expectations, it amounts to a promise of full-blown quantitative easing. That is, the Fed is likely to expand its purchase program and begin adding to its balance sheet again.

Looking back at the year since the last Jackson Hole conference, Ben Bernanke says, “growth during the past year has been too slow and joblessness remains too high. Financial conditions are generally much improved, but bank credit remains tight; moreover, much of the work of implementing financial reform lies ahead of us. Managing fiscal deficits and debt is a daunting challenge for many countries, and imbalances in global trade and current accounts remain a persistent problem.” This is the starting point from which policy makers must think about the work yet to be done.

Turning to the current state of the economy, Bernanke said:

  • Household spending depends on the job situation and the pace at which households repair their balance sheets. One recent piece of good news is the big upward revision in the saving rate from 4% to 6%, which suggests a faster rate of balance sheet repair.
  • Housing is depressed and is likely to remain depressed thanks to the overhang of foreclosed-upon properties.
  • Business investment grew at a rapid pace in the first half but will slow in the second as some of the spending was likely pent up demand from projects delayed during the panic of 2008-09.
  • Bernanke says large firms have access to credit in the bond market, which means their spending and hiring decisions are hampered only by their ability to sell products. Small firms, he says, depend on banks and a reluctance to lend is hurting their ability to spend and invest. (Most bankers we know do not agree with this view. They say the biggest hurdle is the drop in property values which means companies have insufficient collateral to obtain loans.)
  • Labor market data remains disappointing.
  • The rebound in global trade is good for everyone, but the widening of the trade deficit in the second quarter means it has hurt the US (so far). Looking forward, the Fed thinks trade will be neutral to US GDP.

Looking ahead: “Despite the weaker data seen recently, the preconditions for a pickup in growth in 2011 appear to remain in place.”

  • Monetary policy remains very accommodative and financial conditions are improving, which means they are more accommodative to growth.
  • Bank balance sheets are improving and lending standards are starting to thaw.
  • The European authorities reduced fear of sovereign problems.
  • Rising household incomes, better finances and some thawing of credit will help consumer spending next year. [This strikes us as waaay over optimistic given the tightening of credit in response to credit card and mortgage reform and further tightening likely once banks decipher fin-reg reform.]
  • Business investment will slow but stay strongish.
  • The removal of fiscal stimulus should be gradual enough to avoid hurting the economy too much.

“Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households’ incomes and confidence.”

Well said. The Fed is charged with stabilizing prices AND promoting full employment for a reason. Bernanke is saying that the unemployment rate, not the inflation rate, will be the Fed’s primary focus in the year ahead. But, Bernanke went on to say the Fed will not ignore inflation risks. Right now, however, inflation is lower than the FOMC considers healthy.

On current Fed policy: “By agreeing to keep constant the size of the Federal Reserve’s securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred.” In case you missed the WSJ article, the Fed is not really easing policy by investing in Treasuries, it is stabilizing policy.

On future policy: “the Committee is prepared to provide additional monetary accommodation through unconventional measures if it proves necessary, especially if the outlook were to deteriorate significantly. The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.”

Policy options for further easing: “Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists–namely, that the FOMC increase its inflation goals.”

On these, he said:

  1. QE worked in 2009 by improving credit conditions in a number of markets. (FTN believes the primary benefit was tighter corporate bond spreads, because institutional investors shunned MBS and bought corporates to avoid competing with the Fed for bonds.) The biggest impediment to expanding the balance sheet is a likely rise in inflation expectations. He also said that could be a good thing if inflation expectations are too low or negative.
  2. The Fed could change “considerable period” to “a longer period than is currently priced in markets.”
  3. A lower rate on interest paid on excess reserves at the Fed, or the IOER rate would provide banks with an incentive to lend into the private sector rather than leaving cash at the Fed.
  4. Some economists say the Fed should raise its medium-term inflation target to a level above what is desirable in the long-term. There is no support for this option within the FOMC, however.

What the Fed will do going forward: “First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.”

“Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery.”
Chris Low
Although this information has been obtained from sources, which we believe to be reliable, we do not guarantee its accuracy, and it may be incomplete or condensed. This is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. All herein listed securities are subject to availability and change in price. Past performance is not indicative of future results while changes in any assumptions may have a material effect on projected results.

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