BofA Merrill Lynch economist Ethan Harris has been banging the table about the risks that disinflation (falling, but positive inflation) poses to Federal Reserve monetary policy for a while now.
As the chart below shows, several measures of inflation are trending lower on a year-over-year basis. With each new data release, it seems like the amount of annual inflation in the United States economy is moving further and further away from the FOMC's 2% target.
Business Insider/Matthew Boesler, data from Bloomberg
All that means, according to Harris, is that the Federal Reserve is unlikely to stop buying bonds through its quantitative easing program any time soon.
And it seems like even some of the most hawkish Fed policymakers agree.
In a new report, Harris points to evidence of this from recent speeches:
More recently, Fed officials, including some notable hawks, have caught on to the disinflation risks.
Richmond President Lacker reiterated his call for ending QE, but acknowledged that “If I thought [inflation] was going to persist this low or even fall further, I’d of course be giving serious thought to providing monetary stimulus to get the inflation rate back to 2” percent.
On a similar note, Minneapolis President Kocherlakota argued for guarding the inflation target “from below” and St Louis President Bullard said “we should defend the inflation target from the low side.”
In fact, the FOMC may even elect to increase the amount of bonds it buys under the program if disinflation persists. Harris cites the BAML rates team in saying that there is probably room for the Fed to increase its buying of Treasury bonds from $45 billion a month to $70 billion a month.
" Whether the Fed increases QE or not," writes Harris, "as we have seen repeatedly in the last four years, the press, Fed watchers and the market have gotten ahead of themselves in predicting an early exit by the Fed."
The exit, of course, is what everyone is buzzing about. The Federal Reserve's balance sheet recently crossed $3 trillion mark. How does it unwind such a massive portfolio without decimating the bond market? That's what everyone wants to know.
Predicting the bond market's reaction to such an event, Harris says, " involves a complex calculation of (1) how the Fed reacts to the economy, (2) how the bond market responds to the change in Fed policy and (3) how the Fed responds if it doesn’t like the bond market reaction."
No one really knows, because quantitative easing is a new policy tool and there is no historical precedent.
Yet, as Harris points out, " many investors believe each step to the exit—tapering [bond buying], stopping, rolling-off and selling—are fraught with danger."
Ultimately, though, the whole conversation surrounding the Fed exit misses the point on some levels.
Besides, the FOMC might find itself in a position when it comes time to unwind its balance sheet where it needs to engineer a major sell-off in the bond market.
Harris explains why in his report (emphasis added):
In our view, all of this is interesting from a short term trading point of view, but in forecasting the market over the medium term, we think a much simpler approach is warranted. The Fed’s goal is not to manage the size of its portfolio—that is a very uncertain means to an end. What the Fed wants is to manage financial conditions to be consistent with its growth and inflation objectives.
If our forecast is correct—growth picks up above 3% in 2014 and 2015, but inflation remains below target—then we think the Fed will want to engineer a modest sell-off in the bond market. If that means keeping a large portfolio, so be it; if it means selling bonds, that is fine as well. By contrast, if unemployment threatens to drop too far or if inflation picks up notably, then we think the Fed will engineer a major sell-off in the bond market. In the former case, the stock market should rally through the exit, while in the second case, it will likely sell-off.
In other words, investors should not get tangled up in the debate about how the Fed manages its balance sheet. Ultimately, this Fed exit depends on growth and inflation the way it always does. There are two second order differences. On the one hand, the Fed is entering unexplored territory, making mistakes more likely. On the other hand, the Fed has more tools to correct its mistakes, including asset buying and guidance along with its control of short term interest rates. Look for the Fed to aim for a comfortable middle ground.
An eventual orchestrated bond market sell-off may be inevitable, but the bottom line is that investors ought to keep inflation and unemployment – the central bank's two mandates – top of mind.
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