Bernanke's Jackson Hole Hamlet Moment: To QE Or Not To QE?

Agustino Fontevecchia
Bernanke's Jackson Hole Hamlet Moment: To QE Or Not To QE?

The controversial Fed Chairman is once again taking main stage as markets await his comments at Jackson Hole.  Bernanke first tipped the markets about QE2 at Jackson Hole a year ago; while a fragile and slowing economic recovery fueled speculation that the Chairman could announce further monetary stimulus, experts agree rising inflation, and the expectation that the economy will pick-up in the second half of the year, will discourage Bernanke and the rest of the FOMC from unveiling QE3.

When markets fell off a cliff the last couple of weeks, most of the QE2 gains in a variety of assets were erased, forcing the FOMC to release one of its most pessimistic statements yet.  Equities prices both in the U.S. and across emerging markets tanked, oil prices retracted, Treasuries fell below 2% and gold was pretty much the only attractive asset out there, as investors hurried to dig their heads under the sand. (Read The Failure Of QE2: A Look At Gold, Oil, Equities, Treasuries, Emerging Markets, And The Dollar).

GDP numbers delivered one of the biggest blows, with negative revisions showing the economy was growing at a snail’s pace.  Global PMIs indicate considerable weakening in business activity, while “forward-looking order components have been weak, suggesting there is little scope for a quick rebound in activity,” according to UBS.  US activity indicators, says the bank, “reached their lowest levels since March 2009.” (Read US Economic Indicators In Recession Territory, UBS Says).

In his first Jackson Hole speech, Bernanke made clear that of the many effects quantitative easing would have, one was to avert a bout of deflation, while the other was to provide “monetary stimulus” to prop up the economy.  Interestingly, and maybe counter-intuitively, measures of core inflation have begun to pick up in recent months, despite substantial slowing in economic activity.

Experts agree rising inflation will stay the Fed’s hand, meaning Bernanke won’t announce a further round of asset purchases on Friday August 26 when he delivers his speech on “Near- And Long-Term Prospects for the U.S. Economy” at the Kansas Fed. (Read Gold And 10-Year Treasuries' Mirror Image: Stagflation Or Deflation? Bad Outcome Either Way).

Instead, Bernanke will probably announce policies to extend the duration of their portfolio, a so-called Operation Twist, experts at Barclays and UBS agree.  While there’s a few ways the Fed could extend the duration of its portfolio in order to target the longer-end of the yield curve, market observers expect it to sterilize asset purchases by buying longer-dated securities “while selling an equal amount of short-term securities,” according to Barclays. (See Steve Schaefer's piece, Ben Bernanke's Houdini Act).

Under this scenario, an operation of about $300 billion would extend the duration of the Fed’s holdings by one year.  “Such an operation would keep the size of the balance sheet constant while exerting downward pressure on long-term yields by lowering term premiums.”

Operation Twist isn’t without its risks though.  Extending the duration of balance sheet holdings would limit the Fed’s exit strategy capacity, as “the balance sheet would shrink more slowly when the reinvestment policy was removed, since the fewer short-term Treasury securities would be present in the SOMA portfolio.”  Also, Operation Twist could push short-term yields up given the dumping of these securities into the market.

Still, QE3 can’t be taken off the table.  With the Philly Fed manufacturing survey going deep into recession territory last week, a substantial worsening of economic conditions could force the Fed’s hand.  “Easing will become increasingly likely if the recession-like weakness in the Philadelphia Fed manufacturing survey is mirrored in other data,” according to MF Global’s James O’Sullivan.

Renewed risk of deflation would be another factor pushing Bernanke toward QE3.  With PPI and CPI numbers showing a pick-up in core inflation, though, this outcome seems unlikely.  Indeed, with core prices rising despite a weak labor market and softer food and energy prices, “the output gap is likely smaller than many believe and, in turn, is putting less downward pressure on inflation,” according to Barclays. (Read JP Morgan Economist: QE3 Only If We See Deflation, Equities Will Finish 2011 Up 8% To 10%).

But, as UBS’ Manuel Oliveri points out, “the risks associated with another round of stimulus seem to outweigh the positive implications as long as deflation risks do not resurface.”  Commodities, for example, have been highly sensitive “to more stimulus as demand is not only driven by growth expectations but also US dollar debasement fears.”  Rising commodity prices would fuel inflation and hurt consumer confidence.  Political pressure is also high, both inside the U.S. (with the Republican Party taking aim at Bernanke from several angles) and foreign nations like China and Brazil directly blasting QE as ineffective and harming to their economies.

No one can be sure what Bernanke will announce on Friday, but what’s clear is that the Chairman is calling the shots.  Three dissenters, for the first time since 1992, in a “consensus-oriented FOMC,” indicate “the chairman has the responsibility of taking the leadership role, and he has done so repeatedly in recent years. That he and the remainder of the committee proceeded once in the face of three dissents suggests to us that they would again if necessary", according to Barclays. (Read Hayek Is Wrong, And So I Bernanke: The Coming Recession Will Be Deflationary).