Morgan Stanley Expects The Fed To Disappoint On QE 2

Morgan Stanley is out with a research report which indicates the Fed may announce a QE 2 program of around $100 billion a month for six months. If true, this would be much less than the what the market is currently pricing in--expectations are for something around $1 trillion. Personally, I think QE 2 will disappoint because the market has already priced in $1 trillion plus from the Fed. About the only thing that could juice markets higher would be something like $2-4 trillion (Goldman's estimate). The anticipation of QE 2 has distracted the market from the growing crisis in Ireland where CDS continues to blow out at an alarming rate. After QE 2 is finalized, the market will get around to these looming problems. From Morgan Stanley:
The Fed needs to send a clear message. The Fed faces a dilemma: As officials prepare to implement a new round of quantitative easing, they clearly want to adopt a flexible, open-ended approach to asset purchases, one that can be scaled to financial conditions and the economic outlook. Just as clearly, market participants, skeptical about QE's success, will likely gauge the Fed's resolve by the size and pace of the purchase program. We expect the Fed to announce an initial commitment to buy Treasuries at around a US$100 billion monthly clip for the next six months, close to what officials and market commentary have discussed, but less than markets seemed to price in over the past couple of weeks.

How to resolve the dilemma? We think that clear communication about goals and tools would help markets understand the Fed's commitment, which matters more than the size of initial purchases and should give officials the flexibility they need. By underscoring its resolve to achieve specified goals, the Fed could imply how long it will hold on to the assets it purchases. For example, downward revisions to the Fed's inflation forecasts for 2010 and 2011 would imply that policy will be more aggressive for longer to cut off any deflation tail risk. Equally, the maturity distribution of purchases should matter more than the initial size and pace of the program. Skewing purchases to the longer end of the yield curve could increase the bang for buck.

QE eases broad financial conditions. QE1 might provide guidance to estimate the impact of new large-scale asset purchases (LSAPs). Studies suggest that QE1 trimmed nominal Treasury yields by about 50bp, although the econometrics aren't robust enough to narrow a wide range of estimates. It's worth remembering that the decline in Treasury yields is far from the only channel through which QE1 worked; the easing in financial conditions more broadly was as important, and it may be more important today. Easing channels included boosting risky asset prices, depreciating the dollar, and promoting easier financial conditions abroad. It's no coincidence that equity and credit markets bottomed and the dollar peaked (on a broad, trade-weighted basis) just before the FOMC announced that it would buy Treasuries and scale up its purchases of mortgage-backed and agency securities at its meeting on March 18, 2009. Moreover, QE1 had a powerful impact on inflation expectations, judging by the 120bp increase in 5-year, 5-year forward inflation breakevens between March 2009 and April 2010. (Note that distant forward breakevens have risen by nearly 90bp from their August 2010 lows.)

Channels of monetary policy blocked or dysfunctional. The decline in long-term yields and easing in financial conditions should have a positive impact on credit-sensitive demands of the economy. However, it is difficult to quantify the economic stimulus that this will provide, because some traditional channels of monetary policy are blocked or dysfunctional. For example, the plunge in mortgage yields is having a smaller impact on refinancing activity than in the past. Tougher mortgage origination criteria - including ensuring that the loan is no more than 80% of the appraised value of the property, plus verification of the borrower's FICO score and income - have limited the number of eligible borrowers. Originators faced with ‘putbacks' from the GSEs (Fannie and Freddie) on prior loans are understandably skittish to extend credit to less-than-pristine borrowers. And the uncertainty around mortgage foreclosures and putbacks may further tighten the availability of mortgage credit.

What do policy rules say about size of stimulus needed? Traditional policy rules may provide some guidance for how much additional stimulus is needed, but with a wide range of error. New York Fed President Dudley suggests that US$500 billion of purchases would provide as much stimulus as a reduction in the federal funds rate of between half a point and three-quarters of a point. An estimated, traditional Taylor Rule prescribes that under the present circumstances - if policy rates could be negative - they should be -6% or even lower today. Combining these two models suggests that several trillion in asset purchases might be required to achieve the Fed's dual mandate. Given the blockages in monetary policy transmission channels, such estimates may have some validity, especially if policies to fix housing imbalances are unavailable. Yet, those estimates are obviously subject to substantial error.
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