Assessing Fed policy

Stock Watch

by Butterfield’s Brad Bishop

Back in November when the Fed announced QE2, a number of market participants expressed doubt that the program to buy an additional $600 billion in treasury securities until June 2011 would jumpstart the ailing US economy. An even greater number of participants expressed fear that a second round of quantitative easing would substantially weaken the dollar. Fed Chairman Ben Bernanke expected this resistance and went on the defensive. He sent a letter to the Washington Post and wrote of how previous asset-purchase programmes helped end the economic free fall by reducing long-term interest rates. He further wrote about the risks of falling inflation and the importance of maximum employment. He also tried to defend the appropriateness of his strategy to several of his fellow central bankers around the world that were sceptical. Lastly, he continued to express his confidence in the Fed’s ability to fight inflation by explaining the exit strategy for withdrawing monetary stimulus.

Now that nearly five months have passed since the announcement, it is worth assessing the impact of this policy thus far on a number of indicators.

US Dollar – to the dismay of many, the dollar has not fell off a cliff. It has actually increased by just over 1 per cent, as measured by the US dollar trade-weighted index from November 3rd until the time of writing (and at one point was up by 6 per cent in Q4 2010). What has picked up more is talk of currency wars as governments around the world want to protect and grow their export markets.

Economic Growth – recent economic growth figures have marginally declined. The latest annual real growth rate was pegged at 2.7 per cent as at Q4 2010, marginally lower than the 3.2 per cent reported in Q3. The impact of QE2 can’t really be assessed on economic growth as yet.

Long-term interest rates – the 10 year US treasury note yield has increased by nearly one percent since the announcement, from 2.57 per cent to 3.45 per cent, and the 30 year US treasury bond yield has risen by just over half a percent from 4.04 per cent to 4.59 per cent. The increase in longer-term treasury yields has influenced longer-term fixed mortgage rates. On average, 15 year mortgage rates have risen from 3.63 per cent to 4.27 per cent and 30 year mortgage rates have ratcheted up from 4.25 per cent to 5.00 per cent at the time of writing. The increase in long yields and rates has been a global phenomenon driven by increased expectations for inflation.

Inflation – Although expectations have increased, this unconventional easing measure (just like the previous one) has had little visible effect on actual price inflation thus far. The Fed’s preferred inflation measure, Core PCE, which excludes volatile items like food and energy, has barely budged.

Unemployment Rate – the unemployment rate remains very high at 8.9 per cent only slightly down from 9.8 per cent in November.

Although it is impossible and unfair to entirely attribute the above trends solely to QE2, it would be hard to argue that there has been no impact. Whilst the Fed has stated they want to keep long rates low, I would bet that Bernanke is rather happy that inflation expectations have picked up. The Fed’s dual mandate calls for maximum employment and price stability, which can be conflicting priorities. However, with actual inflation running below the Fed’s preferred 2 per cent rate, Fed policy right now is tilted toward reflating the economy to encourage spending now rather than delay purchases. In doing so, the unemployment rate would naturally decline as businesses re-hire.

Will the Fed be successful?

I think it would be unwise to “fight the Fed” but a number of counter forces are at work to slow the success – such as the strong consumer de-leveraging mindset and the unwillingness of big banks to lend out excess reserves. In summary, we will continue to see progress but it will be slow.

The views expressed above are not necessarily those of Butterfield Bank (Cayman) Limited. 
Financial statistics sourced from Bloomberg.

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