In Europe the talks go on but so far we have seen little action. European leaders are in the progress of negotiating a new “euro vision” for the monetary union. The ECB is taking part in the debate. The final outcome will take time, but the emergence of the political could help restore some confidence…….
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Yellen and Bernanke have paved the way for new monetary stimulus. Yellen and Bernanke spoke almost as a single voice in describing the economic scenario and the risks involved, and this certifies that the FOMC is ready to act soon. Both their speeches chose not to dwell on poor recent data, and stressed the importance of underlying trends, less affected by idiosyncratic factors. The economic outlook is still characterised by “moderate growth”, albeit marred by “significant” negative factors, that will considerably hinder return to full employment. Inflation should stay in line with the 2% target, or below. According to Yellen, payrolls expanding at the pace seen on average since the beginning of the year would do little to improve labour market conditions. What’s more, high unemployment is mostly of a cyclical nature, rather than structural. This is the precondition for any monetary policy action, which affects cyclical behaviour, but not structural factors. A drag on growth is coming from: residential construction, fiscal policy, uncertainty, and conditions abroad. US fiscal policy is already restrictive, and will become even tighter in the coming quarters: this is a given. An additional risk factor is the coming into force of automatic fiscal measures at the beginning of 2013, which adds to the uncertainty and depth of negative potential scenarios. International pressures, even assuming a non-deflagration of the European crisis, are already holding back the US economy, via slower exports due to the recession in Europe and to the appreciation of the dollar, and via the contagion carried by global financial conditions. The combination of excessively weak demand to rebalance the labour market, and of downside risks to inflation, provide the logic pressing for new interventions. For the time being, inflation expectations are anchored at 2%, and are halting downside adjustments to prices and salaries, despite the presence of substantial spare resources. However, Yellen notes that a downward spiral of wages and prices could be triggered by an interruption of labour market recovery. Hence a key point: “risk management considerations” strengthen the case for additional accommodation. Yellen said that “if the Committee judges that the recovery is proceeding at an insufficient pace, we could undertake portfolio actions such as additional asset purchases or a further maturity extension programs”. Bernanke assured that the FOMC will assess the strength of the recovery, a “key issue” together with the assessment of price stability. Should it be necessary to intervene, the Fed has “several options”: Bernanke does not to “take anything off the table” and said that the FOMC may have to make “tough decisions” based on “difficult assessments”. In our view, at its June meeting the FOMC could announce new stimulus measures worth around 100-200 billion dollars up to September: either an extension of “operation twist” (lengthening maturity of debt), or an increase in purchases, with their sterilisation. A deterioration of the scenario could prompt the FOMC to introduce new stimulus in September. Obviously, the decision would be taken despite explicit dissent, but we know that Bernanke’s Fed is used to governing with a majority, and does not wait for a unanimous vote to take important decisions.
In Europe, indications have emerged in the past week that high-level talks are under way to redefine the Monetary Union setup. The plan should include the establishment of a European banking sector watchdog, as well as a higher degree of “mutualisation” of fiscal policies and a transfer of powers from the States to the Union. If consensus and political commitment take shape already at the Euro summit at the end of June, the balance of risks could shift considerably. In the meantime, in addition to uncertainty on the outcome of the Greek elections on 17 June, the Spanish front line remains open. It seems that is only a matter of days before the Government will request European support to recapitalize monetary and financial institutions through the FROB. A direct recapitalization of banks without a formal request from Madrid fell off the table. Markets do not seem overly concerned that a EU aid request for banks could impair further sovereign returns, yet conditions could change rapidly.
Appendix
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