Viewpoint: The news is that a new framework agreement has also been reached

Lug 20, 2012

Minute Read

Fed warming up for monetary stimulus: scorching summer on the way for the FOMC. In Europe, the Spanish banking sector bailout has been approved…….

For professional investors and advisers only

The news is that a new framework agreement has also been reached, that would allow swifter decisions to be made on a potential diversion of funds, currently addressed to banks.

– In his testimonies before Congress, Bernanke confirmed that the Fed is ready to act. While the markets were disappointed by the lack of details provided, we believe that Bernanke’s words have further increased the likeliness of QE3. Bernanke leads the FOMC democratically and does not contemplate announcements by the Chairman before a collegiate vote has taken place. As regards monetary policy forecasts, what counts is that Bernanke has signalled the existence of conditions that will probably be considered necessary and sufficient by the majority of the Committee to put in place new actions, more radical than those seen in the past year. In this sense, Bernanke has sent signals that make the use of more than a single stimulus instrument likely within the next two meetings: QE3, communication and possibly credit easing.

The economic outlook described by Bernanke is rather bleak, and weaker than in previous assessments.: a recovery is under way, but is slowing, and the Fed continues to expect a “frustratingly slow” labour market adjustment. The Chairman reasserted that uncertainty is still high and increasing, as are downside risks to the outlook. The risks which concern the central bank most are still the same: the European crisis and US fiscal policy. As regards the future, the Chairman stressed that the FOMC already made it clear in its June communiqué that it is “prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labour market conditions”. Also, there is a return of explicit deflation fears. Bernanke said that “it’s very important we see sustained improvement in the labour market, and avoid deflation risk”: this marks a turning point, which significantly increases the chances of QE3. In the past, deflation fears have always been among the conditions required to prompt quantitative stimulus. Bernanke’s prepared text does not provide details of future action. However, in answering questions, Bernanke confirmed that the Fed is examining different options to promote stronger growth. The most effective instruments, according to Bernanke, are the purchase of securities and communication. The “new tools” probably include credit easing programmes aimed at easing financial conditions on specific markets, and the reduction to zero of the rate paid on excess bank reserves. The first type of intervention seems more likely to us. The cut of the reserve rate had already been discussed by the FOMC and put aside out of fears of a negative fallout on the money market.

On the other hand, credit easing seems to be favoured in light of Bernanke’s focus on constraints on lending to households, repeatedly discussed with considerable concern.
Despite the lack of details contained in the chairman’s testimonies, we continue to expect a QE3 package, probably to be announced at the September meeting, worth around 400-600 billion dollars, largely addressed to MBSs. Possibly already in August, the expected date of the first fed funds rate hike might be postponed from late 2014 to at least mid-2015. In the meantime, the way could be paved for a credit easing programme to be implemented by September. Much will depend on data, although we expect job growth to remain weak and the inflation to keep slowing, allowing the FOMC ample margin for intervention.

– Today the Eurogroup officially approved the programme for Spain. The Memorandum of Understanding includes a new framework agreement that may cover in the future also other rescue programmes (purchase of securities on the secondary or primary markets, precautionary programmes, guarantees on government issues, etc.), as long as the present 100 billion euro ceiling is respected. While no automatic mechanism is provided for (a formal request would in any case be necessary, as well as the negotiation of an additional agreement on specific terms, and a resolution issued by the Eurogroup’s working team), the framework agreement already approved by all the countries will avoid the current lengthy process of obtaining national parliamentary approvals.

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