Don't Bet On QE 2 Just Yet--Morgan Stanley

While Goldman and the rest of the market expect QE 2 to be announced in either November or December, perennial optimist Morgan Stanley is out with a research piece which argues that it might not happen during 2010. Why? Because Morgan believes future economic data will surprise to the upside, particularly Q3 GDP which the firm expects to come in at 2.6%. Furthermore, the firm postulates that more QE will not do much to improve the economy. According to their econometric models, a "$2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012." If Morgan is right there is very little reason for the Fed to initiate a new QE program. It would not materially effect the real economy and would only send gold and other commodities higher. 

Eve though Morgan Stanley thinks the chances are low of more QE, they believe the trigger for any new announcement would be an indication that US GDP growth is trending below 2% for an extended period of time.

From Morgan Stanley:

Renewal of asset purchases unlikely, but it's a close call. We believe that the incoming growth data will be sufficiently positive to prevent the reintroduction of asset purchases in coming months. Indeed, since September 1, our tracking estimate for 3Q GDP has risen from +1.7% to +2.6%. But it's a close call, and the FOMC could act at any time if the data disappoint. So, some analysis of an asset purchase program seems warranted. Here is a brief Q&A:

Q) What is the trigger for renewed asset purchases?

A) This is a tricky one to answer because it's the assessment of tail risk (not the baseline forecast) that really matters. If Fed officials perceive a significant probability that recovery is stalling out, then they have to do something. To be more specific, we suspect that a perception of a one-third or higher probability that GDP growth will slip below the +2% ‘escape velocity' pace for a few quarters would trigger another round of asset purchases.

Q) What is the timing?

A) Could happen at any time (on an FOMC meeting day or even between meetings) since it is data-dependent. In particular, we do not believe that the timing of the November FOMC announcement (the day after the midterm elections) has any bearing on the likelihood of a move at that time.

Q) If implemented, what would the program look like?

A) There is a wide range of options. The Fed could merely revive the LSAPs and announce a targeted amount of buying over a certain timeframe (e.g., $500 billion, $1 trillion, $2 trillion over 3, 6, 9 or 12 months). Alternatively, the Fed could adopt a more flexible approach - recognizing that in the first round of the LSAP, it had to scale back the amount of agency purchases and probably wound up buying too many MBS. Former Fed Governor Don Kohn has suggested a program that would entail a modest starting size that could then be scaled up depending on incoming economic data. Finally, we actually prefer a rate cap approach (along the lines outlined by Bernanke in his 2002 ‘Deflation' speech) whereby the Fed specifies a target for 10-year Treasury yields as opposed to a quantity of purchases. However, we admit that this approach does not seem to be getting much traction inside the Fed these days.

Q) What will be the impact on the markets and the economy?

A) Obviously, this is a critical issue but it is also highly uncertain. Suffice to say that we are skeptical that the economic effects would be large. The Fed might well be successful in driving Treasury yields 25 or 50bp lower from here, but the economic benefits of that outcome alone are minimal in the current environment.

Before analyzing the potential economic impact in greater detail, it's worth highlighting the difference between the Fed's past actions and the asset purchases that are now under consideration. For some reason, the markets seem to equate the term QE with central bank asset purchases. In fact, QE refers to any form of central bank balance sheet expansion. In the US, QE 1 actually started with the introduction of the Term Auction Facility (TAF) and foreign central bank swap lines - and all this occurred several months before the Fed started buying MBS and Treasuries. The initial round of quantitative easing had a clearly defined objective - to provide sufficient liquidity to rein in interbank funding pressures that were contributing to a tightening of credit availability. The Fed's actions were successful in reining in the spike in measures of liquidity stress, such as the Libor/OIS spread.

The second phase of QE, announced in November 2008 and implemented starting in early 2009, involved an effort to drive mortgage rates lower in order to spur refinancing activity and improve housing affordability. Again, this goal was (at least partially) achieved as mortgage rates plummeted. I say ‘partially achieved' because the full impact of the drop in mortgage rates is not making its way through to the consumer due to blockages in the refi channel. We believe that future Fed action aimed at driving rates lower would be far more powerful if it were combined with something along the lines of our ‘Slam Dunk Stimulus' proposal (also, see the op-ed in last weekend's New York Times by Glen Hubbard and Chris Mayer that endorses a similar type of plan). In any case, the main point is that the Fed's easing measures conducted in late 2008/early 2009 were well defined and largely achieved its objectives. In our view, that is not the case with the next phase of asset purchases now under consideration.

Impact of new asset purchase program? Not much bang for the buck. Former Fed Governor Larry Meyer maintains a large-scale macro-econometric model of the US economy that is widely used in the private sector and in public policy-making circles. These types of models are good for running ‘what if?' simulations. Meyer estimates that a $2 trillion asset purchase program would: 1) lower Treasury yields by 50bp; 2) increase GDP growth by 0.3pp in 2011 and 0.4pp in 2012; and 3) lower the unemployment rate by 0.3pp by the end of 2011 and 0.5pp by the end of 2012. However, Meyer admits that these may be "high-end estimates". Some probability of a resumption of asset purchases is already priced in, and thus a full 50bp response in Treasuries is unlikely. Moreover, a model such as Meyer's is based on normal historical relationships and therefore assumes that the typical transmission mechanisms are working. For example, a drop in Treasury yields would lower borrowing costs for consumers and businesses, helping to stimulate consumption, business investment and housing. But there is good reason to believe that the transmission mechanism is at least partially broken at present, and thus the pass-through benefit to the economy associated with a small decline in Treasury yields (relative to current levels) would likely be infinitesimal.


1 comment:

  1. The problems caused by unchecked money printing are unthinkable.