The Federal Reserve provided further support this week to our dovish thesis, which postulates that interest rate policy will stay at, or below, current levels well into 2012. In addition, the door for a third round of quantitative easing was opened ever so slightly based on our read.
The interesting change in the Fed’s statement versus its last one is an acknowledgement of slower than expected economic growth and a jobs recovery. The outcome of these two changes is that the Fed has, tacitly, taken down its expectations for inflation:
“Inflation has moved up recently, but the Committee anticipates that inflation will subside to levels at or below those consistent with the Committee’s dual mandate as the effects of past energy other commodity price increases dissipate.”
Fed chief Ben Bernanke reiterated this in his press conference on Wednesday, in which he said, “inflation remains well anchored.” Our read through on this is that these statements are a shift and in contrast to his statement at the International Monetary Conference in early June when he said:
“That said, the stability of inflation expectations is ensured only as long as the commitment of the central bank to low and stable inflation remains credible. Thus, the Federal Reserve will continue to closely monitor the evolution of inflation and inflation expectations and will take whatever actions are necessary to keep inflation well controlled.”
Reading too much into snippets of “Fed speak” is dangerous at best, but it does provide some insight into what could happen next. Bernanke is now admitting both that the economy is getting worse and that he believes the outlook for inflation is now likely to be at lower than normal levels going forward. So, the door has now been cracked open for QE3.
We continue to believe the Fed will need sustained negative monthly payrolls in order to actually implement QE3. Prior to QE1, this was 9 negative months, while prior to QE2 this was 3 negative months. In May, non-farm payrolls came in at +54K, which was an eight-month low. The June non-farm payrolls will be released on July 8th and will be the key measure as to the direction of monetary easing from here. If we get a negative print, QE3 will be solidly on the table.
That said, the Fed will likely not implement additional easing while inflation, as measured by CPI, is accelerating. While we have been of the view that reported inflation will continue to accelerate or be heightened during the summer and into the early fall, by early 2012 this should reverse. Thus, heading into 2012 tougher comparables on commodity inflation will potentially lead to deflationary type concerns, or at least give the Fed complete cover for incremental easing, especially as the labor market is likely to remain challenged.
The Fed also released its updated economic projections based on the “models” of the board members. For 2012, they are taking down growth expectations, taking up unemployment expectations, and increasing inflation expectations. Here at Hedgeye, we actually call slowing growth, increasing unemployment, and increases inflation, Jobless Stagflation.
Bernanke also indicated that keeping the federal funds rate at 0% to 0.25% for an extended period means for at least two to three FOMC meetings. This would extend Bernanke’s tenure as the most accommodative chairman in, well, the history of the Federal Reserve. This is outlined in the table below.
If there is anything we can take away from the Fed’s projections, it is that they are based on lagging indicators and are seemingly inaccurate as it relates to actual economic outcomes. Collectively, this is a little disconcerting since monetary policy is set and based on these “projections.”