Friday, September 14, 2012

Will Fed's Bazooka 'Destroy the World'?

The Salt Lake Tribune reports, Fed: We’ll step in as long as it takes:
The Federal Reserve unleashed a series of bold and open-ended steps Thursday designed to stimulate the economy by boosting the stock market and making it cheaper for people to borrow and spend.

The Fed said it will spend $40 billion a month to buy mortgage bonds for as long as it deems necessary to make home buying more affordable. It plans to keep short-term interest rates at record lows through mid-2015 — six months longer than previously planned. And it’s ready to try other stimulative measures if hiring doesn’t pick up.

But perhaps more significant was the basic change in its approach. For the first time, the Fed pledged to act until the economy improved, rather than creating another program with a fixed endpoint.

In announcing the new policy, the Fed sought to make clear that its decision reflected not only an increased concern about the health of the economy, but an increased determination to respond — in effect, an acknowledgment that its approach until now had been flawed.

"The idea is to quicken the recovery," Chairman Ben Bernanke said at a news conference. But Bernanke made clear that he thinks the economy will need the Fed’s help even after the recovery strengthens.

Stock prices rose steadily after the Fed’s midday announcement. The Dow Jones industrial average closed up more than 200 points and cleared 13,500 for the first time since the beginning of the Great Recession. The average is within 625 points of its all-time high.. Other stock averages also surged.

The Fed’s policy committee announced the aggressive actions after a two-day meeting. Its moves pointed to how sluggish the U.S. and global economies remain more than three years after the Great Recession ended.

Thursday’s announcement marked the Fed’s latest dramatic intervention since the financial crisis erupted in 2008 and the Great Recession shot unemployment into double digits. The Fed cut its benchmark short-term rate to near zero and has kept it there for nearly four years. And it’s bought more than $2 trillion in Treasurys and mortgage bonds to try to drive down long-term rates.

Yet for all that, the U.S. economy is still struggling. The unemployment rate is 8.1 percent. And the Fed estimated Thursday that the rate will fall no lower than 7.6 percent in 2013.

The Fed’s latest actions come a week after the European Central Bank announced its most ambitious plan yet to ease Europe’s financial crisis by buying unlimited amounts of government bonds to help countries manage their debts.

With less than eight weeks left until Election Day, the economy remains the top issue on most voters’ minds. Many Republicans have been critical of the Fed’s continued efforts to drive interest rates lower, saying they fear it could ignite inflation.

Asked at his news conference whether the Fed considered the impact of its actions on the presidential election, Bernanke said: "We make our decisions based entirely on the state of the economy. We just don’t take those factors into account."

The Fed on Thursday also lowered its outlook for economic growth this year, though it’s more optimistic about the next two years. It expects growth to be no stronger than 2 percent this year. That’s down from its forecast of 2.4 percent in June.

It thinks the unemployment rate will be no lower than 6.7 percent in 2014. It also expects inflation to remain at or below 2 percent for three more years.

At his news conference, Bernanke made clear that higher stock prices are among the Fed’s goals in buying bonds. Bernanke noted that stock gains increase Americans’ wealth and typically lead individuals and businesses to spend and invest more.

But some economists said they thought the benefit to the economy would be slight.

"We doubt it will be enough to get the economy on the right track," said Paul Ashworth, an economist at Capital Economics. "It’s only a matter of time before speculation begins as to when the Fed will raise its purchases from $40 billion a month."

The Fed’s ability to increase home buying might be limited even if its bond purchases help lower mortgage rates. The average rate on a 30-year fixed mortgage is 3.55 percent. That’s barely above the record low of 3.49 percent set in July.

While the U.S. housing market has improved, it has a long way to go to reach a full recovery. Some economists forecast that sales of previously occupied homes will reach about 4.6 million. That’s well below the 5.5 million annual sales pace considered healthy.

Bernanke himself sought to lower expectations about how much the Fed’s intervention might help the economy.

"We’re just trying to get the economy moving in the right direction, to make sure that we don’t stagnate at high levels of unemployment," he said at the news conference. "All that being said, monetary policy, as I’ve said many times, is not a panacea."

The Fed’s statement was approved 11-1. The lone dissenter was Richmond Fed President Jeffrey Lacker, who worries about igniting inflation.

The Fed’s new bond purchases, which will start Friday, amount to less per month than either of its first two bond programs. But by committing to buying bonds indefinitely, the Fed is seeking to assure investors and consumers that borrowing will remain cheap far into the future.

"In many ways, today’s actions represent the beginning of a new phase in Bernanke’s efforts to get the economy moving again," said Michael Feroli, an economist at JPMorgan Chase Bank.

Some economists suggested that the Fed might continue to buy $40 billion a month in mortgage bonds for up to three years. That’s how long some expect it will take for the unemployment rate to dip below 7 percent, toward a "normal" rate of 6 percent or less.

If the new bond buying lasts three years, Ashworth said it would add about $1.4 trillion to the Fed’s purchases. That would be close to the $1.7 trillion the Fed spent in its first round of bond buying, which began in November 2008, at the height of the financial crisis. It ran until March 2010.

The Fed’s second bond-buying program totaled $600 billion. It ran from November 2010 through June 2011.
You can read the FOMC statement below (highlighted the key passages):
Information received since the Federal Open Market Committee met in August suggests that economic activity has continued to expand at a moderate pace in recent months. Growth in employment has been slow, and the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed. The housing sector has shown some further signs of improvement, albeit from a depressed level. Inflation has been subdued, although the prices of some key commodities have increased recently. Longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
Must admit, the Fed's bold move caught me off guard. Had a feeling they were going to announce something but not an open-ended commitment to QE until labor market improves "substantially". Employment growth was weakening but it's a lagging indicator and it wasn't that bad to warrant such an indefinite commitment.

Clearly the Fed is worried the US economy is stalling or worse still, heading for a prolonged deflationary cycle. Why make such a pledge at a time when the economy is seemingly on the mend? One reason, it wants to bolster confidence in the banking system and corporate world so banks start lending more aggressively and businesses pick up hiring. It also wants to prop up stocks and housing so consumer confidence picks up and people continue spending.

Now that the Fed has done its part, it's Congress's turn to deal with fiscal problems. But during the press conference on Thursday afternoon, Bernanke said the fiscal cliff wasn't his only concern (emphasis is mine):
Bernanke: It's pretty hard to give you a number, but I can -- I can certainly confirm as the reserve bank presidents and governors made their reports today and yesterday around the table, there was considerable discussion of uncertainty including policy uncertainty, fiscal policy uncertainty and the implications of that for hiring and investment decisions. A lot of -- a lot of firms are waiting to see whether -- whether that problem will be resolved. And if so, how? And I think it is a concern. It is something that is affecting behavior now. But again, I don't know -- I don't have a number. I don't know how big that effect is but certainly the sooner that can be resolved, sooner can be clarified it will be beneficial not just because we avoid the cliff itself but because we clarify for firms, for employers and investors how that's going to be resolved. So I think it's -- it's an issue that is of some consequence, yes.

-----

Bernanke: We take the economy as we find it. There are a lot of headwinds right now that are affecting the economy. There are fiscal head winds, there are international factors including the situation in Europe. There are factors arising from still impaired credit markets and so on. So we looked at that -- looked at the economy from the perspective of, you know, how quickly it's been growing over the last six months to a year and as I talked about in a speech in March -- in order for employment gains to be sustained for unemployment to fall, the economy needs to grow at or above trend levels. And lately it's not really been at trend. So we've been responding to that problem, and trying to take steps that will ensure somewhat stronger growth and we hope will help bring unemployment down over time.

Now, again, the fiscal cliff, the uncertainty of the fiscal cliff one of the factors one of the head winds but I'm sure there are many others and we don't try to differentiate among them in any sense. If the fiscal cliff does occur, I suspect it won't and I hope it won't but if it does, and we get the kind of impact the congressional budget office is talking about, as I've said, I don't think the Federal Reserve has the tools to offset that and we would have to rethink it at that point. But we've taken the steps we've taken now because we'd like to see the economy gather more momentum and the more momentum it has, the better placed we are to deal with any shocks that might come down the road.

The key word in that last passage was momentum. The Fed will do whatever it takes to ensure momentum continues in the economic recovery, even if it means erring on the side of inflation.

Not surprisingly, stocks, commodities and precious metals all soared and the US dollar fell along with Treasuries as the Fed plan boosted inflation expectations:
Treasuries fell, pushing the yield on the 30-year bond above 3 percent for the first time in four months, as inflation expectations surged after the Federal Reserve’s decision to buy more debt to strengthen the economy.

The yield gap between 10-year notes and comparable Treasury Inflation Protected Securities, an indicator of traders’ outlook for consumer prices over the life of the debt, reached the widest in 16 months. Treasuries remained lower as consumer prices and retail sales rose in August. The Fed said yesterday it will purchase $40 billion of mortgage debt a month.

“The central-bank policies are inflationary,” said Dan Mulholland, head of U.S. Treasury trading in the capital markets unit of BNY Mellon Corp. in New York. “Therefore the long end of the curve has lost sponsorship. The Fed really put the bazooka into the market yesterday with the monetary policy they are pursuing.”

Benchmark 10-year yields increased nine basis points, or 0.09 percentage point, to 1.82 percent at 8:47 a.m. in New York, according to Bloomberg Bond Trader data. They climbed as much as 11 basis points, the biggest one-day rise since July 27. The price of the 1.625 percent security due in August 2022 slid 27/32, or $8.44 per $1,000 face amount, to 98 1/4.

The 30-year bond yield added 10 basis points to 3.03 percent, after rising to 3.05 percent, the highest level since May 10. Thirty-year bonds, because of their long maturity, are more sensitive to inflation than shorter-dated Treasuries.
Break-Even

The difference in yields between 10-year notes and TIPS increased to as much as 2.54 percentage points, the most since May 2011, versus an average of 2.16 percentage points over the past decade. The gap is known as the 10-year break-even rate.

The Stoxx Europe 600 Index (SXXP) climbed 1.3 percent, while Standard & Poor’s 500 Index futures added 0.3 percent.

Treasuries were the most volatile among developed-market government bonds today, according to measures of 10-year bonds, the spread between two-and 10-year securities, and credit default swaps.

TIPS have returned 6.2 percent this year, versus 1.7 percent for Treasuries that do not provide inflation protection, according to Bank of America Merrill Lynch indexes. Thirty-year bonds gained 0.9 percent, based on the gauges.

The U.S. consumer price index rose in August 0.6 percent from the previous month and 1.7 percent from a year earlier, the Commerce Department said today, matching the forecast in a Bloomberg News survey.

Retail sales increased 0.9 percent, compared with a revised 0.6 percent the previous month and a Bloomberg survey forecast of 0.8 percent.
Accommodative Stance

Fed Chairman Ben S. Bernanke is trying to bring down an unemployment rate stuck above 8 percent since February 2009.

“We’re looking for ongoing, sustained improvement in the labor market,” he said at a press conference yesterday in Washington following the conclusion of a two-day meeting of the Federal Open Market Committee.

The FOMC said it would probably hold its target for overnight bank lending near zero “at least through mid-2015.”

The Fed also said it will maintain its current program of swapping shorter-term Treasuries in its holdings with those due in 6 to 30 years to put downward pressure on long-term borrowing costs.

The central bank is scheduled to buy as much as $2 billion of debt maturing from February 2036 to August 2042 today as part of the plan, according to Fed Bank of New York’s website.
TIPS rallied sharply yesterday but I'm not convinced inflation is coming back into the economic system in any significant way, so take some profits on TIPS, gold and silver. Moreover, QE may not be so bad for the US dollar and think investors shorting the greenback should cover.

From an international perspective, the Fed's announcement raises the stakes for the Bank of Japan to expand its own bond purchase program and twists China's view of Fed stimulus:
The Federal Reserve's move to pump up growth in the U.S. will rouse howls of protest in China. In fact, the Fed is doing the job of Chinese policymakers for them.

Two years ago, China's consternation at the Fed's quantitative easing was easy to understand. Beijing was trying to manage down its domestic stimulus measures and feared a flood of hot money stoking inflation and asset price bubbles. This time round is different.

China's great summer mystery--apart from the disappearance of President-in-waiting Xi Jinping--is why the central bank hasn't done more to support growth. Growth in industrial output and exports is at its lowest level since the financial crisis. Yet monetary policy remains relatively tight.

Now the Fed has done Chinese policymakers a favor. If past experience is anything to go by, quantitative easing in the U.S. will spark a wave of capital flows to emerging markets. Inflows of capital should buoy China's flagging real estate and equity prices, and pump up liquidity in the banking system, pushing bank lending and investment higher.

Assuming the Fed's move has the desired impact on the U.S. economy, China's factories--and those across Asia--should see slightly stronger growth in exports too.

There are negatives. Higher commodity prices will mean imported inflationary pressure. China shouldn't be too troubled given producer prices are falling and consumer prices are rising at a very moderate 2% a year. Asian neighbor India, with inflation uncomfortably high and dependence on oil imports, will suffer more. A weaker U.S. currency will reduce the purchasing power of Asia's enormous dollar reserves as well.

But for China, a move that should help solve its immediate problems with growth and boost demand from its biggest export customer, looks like more of a benefit than a cost.
Of course, there will be plenty of skeptics who think Bernanke's sugar hit for markets will not last, but I caution investors, the biggest risk going forward is a melt-up, not a crash. Judging by the massive cyclicals euphoria I'm witnessing, I'd say markets are sensing the global economic recovery will pick up steam heading into 2013. We'll see how long this lasts but pay attention to cyclicals.

Below, Michael Darda, chief economist and chief market strategist at MKM Partners LP, talks about the Federal Reserve's plan for open-ended large-scale asset purchases and the outlook for financial markets. He speaks with Tom Keene and Sara Eisen on Bloomberg Television's "Surveillance."

And for all you bears, Marc Faber, publisher of the Gloom, Boom & Doom report, talks about Federal Reserve policy and his investment strategy. Faber, speaking with Betty Liu on Bloomberg Television's "In the Loop," also discusses gold prices, the property market and explains why he thinks Fed policy will 'destroy the world'.