QE3.5?

2012-NOV-16

Ben Bernanke and the Federal Reserve have been consistent in their pledge to provide incredibly accommodative conditions whenever there has been weakness in the economy. For the past year they pledged to stand ready if the data weakened, and when it did, they launched "QE3" (known to others as QE to infinity). Now there is a good chance they might be expanding the size of that bond-buying package. The Fed is already buying mortgage securities through QE3, and when Operation Twist expires they may continue buying the longer-dated Treasuries and stop selling the shorter-term paper.

There is inconsistency in many of the arguments made by the Fed. But they have been incredibly reliable when they say they will expand their balance sheet if the data is weak. I wrote about the Fed’s policy in April after the March Fed minutes were released:

“On April 3 the Federal Reserve released minutes from its March meeting, which the markets interpreted as downplaying the probability of imminent stimulus measures. While different Fed officials place different emphasis on the likelihood of more easing, they are all in basic agreement that the decision on further monetary stimulus is based on whether the economy is recovering. If there are signs that the economy is once again faltering, they will indeed ease.”

The data weakened throughout the summer and the Fed responded with QE3. So far QE3 has expectedly provided little relief, and signs of weakness in growth and labor continue to emerge:

“Ford Motor Co. (F) and Dow Chemical Co. (DOW) joined a growing number of companies firing thousands of workers as sluggish U.S. growth and Europe’s deepening recession lead to a persisting slump in sales.

North American companies have announced plans to eliminate more than 62,600 positions at home and abroad since Sept. 1, the biggest two-month drop since the start of 2010, according to data compiled by Bloomberg. Firings total 158,100 so far this year, more than the 129,000 job cuts in the same period in 2011.”

This is the type of data that catches the Fed’s eye. Governors have publicly commented that they would be in favor of almost unlimited asset purchases until the labour picture improves, it might be wise to take them at their word.

Companies are also starting to speak out about the effects that the unresolved fiscal cliff is having on their ability to plan:

“Back in the U.S., companies are hesitant to expand until they know the result of the presidential election and how lawmakers will handle the so-called fiscal cliff, or the $607 billion in tax increases and spending cuts set to take effect in January if Congress doesn’t intervene. Inaction probably would cause a recession in the first half of 2013, according to the Congressional Budget Office.”

Shortly after the cliff is resolved (with real budget cuts no doubt delayed once more) the US government will be reaching its "debt ceiling" again, which is unlikely to make business planning that much easier. Businesses must find it challenging to plan around the volatile monetary policy of the past four years; forcing as it does CEOs to become part-time Fed watchers.

These conditions leave a weak market with little to point to that will improve in the near term. Given what the Fed does in these situations an expansion of QE3 is looking more and more likely. The Fed has already hinted at expanding QE3 as Operation Twist ends and the data only increases this probability. All eyes will be on the December Fed meeting to see how the situation is resolved.