Wednesday, January 18, 2012

5 reasons QE3 is now off the table

The third round of quantitative easing (QE3) by the Federal Reserve appears completely unlikely at this stage. Here are the reasons:

1. PPI ex-food/energy, a leading indicator for CPI which is monitored closely by the Fed, has been rising at a decent clip with the latest number at 3% year-over-year.  This will make the FOMC think twice about injecting additional liquidity.

PPI ex food and energy YOY (Bloomberg)

2.  Capacity utilization, though low by historical standards, has been growing.  The latest number is quite strong, particularly excluding utilities which are operating below capacity due to warm weather. In fact manufacturing output increased 0.9% m/m in December.

Capacity utilization relative to 2007 (source: the Fed)

3. Whether by design via "operation twist" or due to flight into treasury markets because of the European concerns, the Fed got their desired result of flattening the treasury curve.  The flattening in the last six months has been quite sharp. 

US treasury curve move in the last 6 months (Bloomberg)

That curve flattening in turn brought down mortgage rates considerably. Incremental outright asset purchases will accomplish little in that regard.

30y mortgage rate (

4. It is not clear that quantitative easing has a meterial impact on broad money aggregates.  The chart below shows the M3 aggregate as calculated by Capital Economics (the Fed no longer computes that number).  QE2 was started in November of 2010, when M3 growth was already climbing off its lows.  And in spite of tremendous injection of liquidity into the system, M3 growth continued to lag materially the narrower money aggregates. 

Source: Capital Economics (* M3 is their calculation, not the Fed)

5. QE3 is the last "bullet" of any consequence the Fed currently has in its arsenal.  With short-term rates locked in at zero for two years and mortgage rates at historical lows, the impact on the US economy from additional liquidity will be minimal if not negative. Therefore the only time the Fed would consider using its last bullet is if we experience a global credit crisis such as a sudden default of a major EU financial institution or a large eurozone sovereign.  And the eurozone and the ECB have proven that they will simply not allow for that to happen.
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