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Milken Institute | Newsroom | Currency of Ideas - The Fed’s dilemma: do the latest economic data justify QE3? Currency of Ideas: The Fed’s dilemma: do the latest economic data justify QE3?
July 06, 2012 at 03:21 PM
The Fed’s dilemma: do the latest economic data justify QE3?
  Posted by
Phillip L. Swagel
Phillip L. Swagel
 
The employment report for June shows only 80,000 new jobs added– below expectations of 100,000—and the unemployment rate stuck at 8.2 percent. This pace of job creation is consistent with modest U.S. GDP growth rather than recession, but is still deeply unsatisfactory. The data prolong the Fed’s dilemma, as the economic outlook is for sluggish growth but perhaps not weak enough to justify extraordinary steps such as renewed bond purchases under the rubric of QE3.

While the unemployment remained unchanged, average monthly job growth in the second quarter of this year slowed to 75,000 from 226,000 jobs added each month in the first quarter. A broader measure of unemployment including discouraged workers rose slightly to 14.9 percent, erasing the improvement since February. Today’s data included some modest positive signs: average weekly hours worked rose slightly so that the overall number of hours increased as well, and wages are up by 2 percent over the past year, which is probably slightly ahead of inflation (inflation data for June will be released on Tuesday, July 17).

Recent data suggest tepid GDP growth of 1.5 to 2 percent in the second quarter that just ended, after 1.9 percent growth in the first quarter. Growth in the manufacturing sector has slowed, with the June Institute of Supply Chain Management survey of manufacturing purchasing managers coming in below the break-even level of 50 for the first time in three years. Indicators of new orders and exports were also both down, and manufacturing job gains slowed as well.

The picture is somewhat brighter for the services industry. The most recent purchasing manager survey revealed the weakest reading since January 2010, but still above the break-even point at 52.1. The consumer is also showing signs of fatigue, with confidence measures on a downward trend for four consecutive months, despite lower gasoline prices. Broad measures of consumer spending have also shown anemic growth, though there are now promising signs that the housing market is stabilizing, with home sales rising and prices (finally) starting to firm.

The weak outlook for key U.S. trading partners poses additional downside risks as the Fed contemplates further action following recent steps taken by foreign central banks to prop up markets. The European Central Bank this week cut interest rates 25 basis points to a corridor of 0 to 0.75 percent, while the Bank of England expanded its quantitative easing program and will purchase additional gilts to £375 billion, up from £325 billion.

China’s central bank, the People’s Bank of China (PBOC), also took steps to stimulate growth by cutting interest rates and liberalizing lending requirements: lending rates were reduced from 6.31 to 6.00 percent, deposit rates are now down to 3.00 from 3.25 percent, and banks are authorized to lend at an interest rate as low as 70 percent of the benchmark of 6 percent (meaning that they can lend at 4.2 percent instead of 5.05 percent previously). This last lending restriction was eased just a month ago from 90 percent to 80 percent. Finally, the PBOC is reported to be adding liquidity at banks, and recently cut the required reserve ratio to spur lending. Chinese authorities are likely comfortable taking these expansionary actions since the inflation data for June to be released on Monday is expected to come in at a manageable 2.2 percent, down from 3 percent in May and over 6 percent a year earlier.

From the Fed’s view, beyond sluggish U.S. data and the foreign bank actions noted above, there are a number of significant risks to growth that will factor into thinking about further expansionary monetary action. First, the threat of a European meltdown remains real, with no viable long-term solution yet proffered for Greece, Spain, and Italy; that said, outright collapse of the common currency or of the member countries’ banking sector does not appear to be an imminent risk. Second, continued Iran-U.S. saber-rattling over Iran’s nuclear program has boosted crude oil prices and could do more. Third, there remains real concern over decelerating growth in China. And finally, the looming “fiscal cliff” poses the risk of a recession.

With inflation slightly below the Fed’s implicit target of around 2 percent and the job market weak, this naturally raises the question of whether further monetary action is forthcoming. The problem for Chairman Bernanke is that even QE3 might have only a modest positive impact on the economy unless done in a huge fashion—a size of bond purchases, for example, large enough to substantially lower long-term interest rates and boost inflationary expectations, both of which would combine to reduce the real interest rates that impact business investment and consumer spending.

But intentionally raising inflation above the target range is a virtual act of heresy, given the legacy of low inflation left by past Fed chairs Paul Volcker and Alan Greenspan. For sure, the Fed would act if inflation appeared to be heading toward zero or outright deflation—this was an important motivation behind the late-2010 QE2 program. This is not the case today. The Fed badly wants fiscal policy to support the economy rather than having to consider monetary policy steps such as QE3 that will be controversial and likely have modest impact.

Heading into the November elections, the economic trajectory appears to be slow growth, high unemployment, and global uncertainty.

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