Fed Chairman Bernanke
laid his remaining policy cards on the table last Friday from Jackson Hole,
Wyoming at the Kansas City Fed central bank meeting. Re-launching quantitative
easing (QE) — where large-scale asset purchases would be seen as countering
deflationary pressures — is clearly an option if the U.S. economy continues to
post sub-trend growth. The Fed announced a large scale QE back in March 2009
with $1.45 trillion in mortgage-backed securities, agency and treasury
purchases.
The Chairman acknowledged that the economy is weaker and said
growth during the past year has been "too slow" and unemployment too high. He
also noted that, although most of the drivers for growth over the past year or
so had been softening recently contrary to FOMC expectations, he expected the
economy to expand a moderate pace in 2010 and at a somewhat faster pace in
2011.
The Fed is clearly wary of the risk of a renewed recession after
the recent string of weak economic data. The Commerce Department showed last
Friday that the U.S. economy grew at a mere 1.6 percent in Q2. Figures last week
also showed a further slide in home sales and a drop in business spending on
equipment, prompting economists to raise the chance the U.S. is falling back
into recession.
Bernanke said the FOMC was prepared to offer further
accommodation, if warranted. He said the Fed will do all it can to ensure the
recovery is sustained, and reiterated the Fed has all the tools necessary:
additional purchases of longer-dated securities, modifying the FOMC's
communications, and lowering interest paid on excess reserves. Bernanke said
that the Fed's purchases of long-term government securities have been effective
in lowering borrowing costs and the benefits of buying more such assets, if
needed, would outweigh any disadvantage. It appears the preferred next step
would be large scale purchases of Treasuries that would further expand the Fed's
balance sheet.
Status Quo Maintained in the Short Term
Economic
data on how the U.S. economy continues to evolve holds the key for future
actions by the Fed and for foreign exchange. Bernanke made it clear that the Fed
has not decided what would prompt additional easing. Given this wait and watch
mode, expectations for QE decline significantly in the short term. Major
currencies will remain in the same trading patterns that had established before
his remarks — a stronger JPY against most currencies and good USD support versus
the EUR. Fear that a slowing U.S. recovery will drag the global economy into
another recession sent investors into buying government bonds and perceived safe
haven currencies such as JPY, CHF and the USD in recent weeks. If upcoming data
continue to be weaker-than-expected, the appetite for risk could remain subdued
and is positive for these safe currencies, while risky assets will be under
pressure.
Ineffective Stimulus Will Pressure USD in the Long
Run
If the Fed decides to undertake QE towards this fall, the USD will be
under downward pressure with the potential of a USD sell-off. The Fed will be
viewed by investors that it is running out of effective ways to stimulate the
economy. The renewed QE will be seen as a desperate measure for the Fed to
monetize the fiscal deficit under disappointing recovery prospects, which could
damage the perception of the quality of the U.S. assets. The monetized fiscal
deficit will lead to inflation expectations and lead to selling of the USD by
investors.
Cynicism towards additional monetary and fiscal stimulus has
also increased. The effectiveness of QE to jumpstart growth is questionable in
the current low rate environment. Monetary stimulus hits diminishing returns at
low yield levels, just as fiscal stimulus does at current high spending levels.
An important prerequisite for a rebound in growth is the confidence on the
economic outlook among consumers and businesses. Keeping rates too low for too
long will send the wrong message to consumers and investors as it destroys the
nascent hope about the economic outlook and makes the future more uncertain for
consumers and companies. The long-term prospects of disappointing growth and
apparent lack of responses to traditional monetary stimulus (and also fiscal
stimulus) are likely to weigh on the USD.
The views expressed in this column are solely those of the author and do not
reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its
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