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arrest the slow growth dynamic we seem to be falling
into. The recent failure of a USD 140bn stimulus bill
that included aid to states and unemployment benefit
extensions to pass the Senate highlights the lack of
political will for further deficit spending. This is not a
philosophical or theoretical issue, but a clear
message from voters to Congress in an election
year. It appears US voters don’t necessarily object
strongly to the Japan-like scenario of slower growth.
This could shift if economic conditions deteriorate
much further but there seem to be constraints on
how much more fiscal stimulus can be delivered in
the US.
The situation is different in Europe. Countries in the
periphery have to tighten fiscal policy hard in order to
try to restore credibility and overcome a potential
inability to sell debt. Ideally, in these circumstances,
we would have liked to have seen the countries with
better fiscal conditions refrain from tightening, or
even supplying a bit of temporary stimulus in order to
support overall aggregate demand. In fact, the
reverse is happening with Germany intent on
tightening policy to set an example. Our view is that
Germany’s expansion owes far too much to exports
and far too little to aggregate demand. A bit of fiscal
push – or a lack of brake – when the momentum in
the traded goods sector was strong could have
helped the recovery spread more broadly to the nontraded
sector. However, that was not to be. Overall,
the fiscal tightening, together with the effects of the
fiscal crisis (lower confidence, likely less willingness
to supply credit by banks) led us to halve our growth
forecast for the eurozone in 2011 to 0.6%.
The choices for monetary policy are also very
difficult
The choices for monetary policy are also very
difficult. In general, it is easier to be aggressive and
creative when you are addressing liquidity crises or
the potential for a second Great Depression and
much harder when the scenario is a Japan-like
outcome of slow growth and no inflation. There are a
few easy first steps. The Fed already took the first
step toward lengthening the horizon for zero rates in
June by citing financial tightening and acknowledging
the downward trend in inflation. It could further
strengthen its language around the inflation and
employment conditions that would lead to both
further easing as well as tightening. Beyond rhetoric,
the Fed could easily announce that it will re-invest
the MBS rolling off, a decision that would forestall a
decline in its balance sheet of USD 100bn-150bn per
year that would otherwise begin in H2. This would be
a signal that it is willing to maintain the current easy
stance of policy and wouldn’t require a new facility or
the re-initiation of an expired facility. Doing so would
imply it would absorb 40-60% of net new mortgage
supply at current rates. It could also lower the
Chart 3: Core Prices are Decelerating
Source: Reuters EcoWin Pro
interest it is paying on reserves from 25bp to zero,
although this could lead to dysfunction in overnight
funding markets (hence leaving it at 25bp and
keeping a target for fed funds as a range between
zero and 25bp even at the height of the crisis).
Further expansion in central bank balance sheets
would be predicated on a worsening in economic
and financial conditions from here
Phase two of quantitative easing, which is to say a
further expansion in the Fed’s balance sheet, would
be predicated on a worsening in conditions from here
that could include deterioration in the labour market,
further pronounced deceleration in inflation that
appears to be leading to deflationary expectations
(one could argue we are getting close with
Treasuries where they are), indications that housing
is slipping back into dangerous territory, or more
pronounced financial market distress.
Housing is still a source of systemic risk as a further
significant leg-down in prices could produce a wave
of strategic defaults and bank losses. This could
prompt the Fed to invoke 13.3 (acting in “unusual
and exigent circumstances”) and add another
tranche of MBS purchases. While buying Treasuries
is the purest form of quantitative easing – and the
ease of exit is certainly something that recommends
it – these purchases would likely raise political and
market concerns that the Fed is monetising the debt.
The Treasury purchase programme was widely
viewed as ineffective by the Fed and certainly
Treasuries are the asset class least in need of
support. QE II would thus more likely be based on a
serious worsening in conditions that would facilitate
the invocation of 13.3 and further credit easing.
There is a scenario in between that does not have
an easy policy prescription – the muddle-through
scenario we are currently in
Beyond committing to zero rates and a stable
balance sheet, it seems difficult to announce a bold
Julia Coronado and Paul Mortimer-Lee 16 July 2010
Market Mover
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