Wed, 6 Jun 2012
Market-driven rate declines and lower inflation should be an automatic stimulus to the economy, reducing the need for further Fed intervention, says Morningstar's Bob Johnson.
Note to readers: Due to travels, Bob Johnson could not post a written column this week; we are publishing this video report, filmed earlier this week, in its place.
Jason Stipp: I'm Jason Stipp for Morningstar.
The markets rallied on Wednesday on hopes that the Federal Reserve would increase stimulus in light of some recent disappointing data and events in Europe.
Here with me to talk about the ramifications of additional stimulus is Morningstar's Bob Johnson, director of economic analysis.
Thanks for joining me, Bob.
Bob Johnson: Great to be here.
Stipp: The markets were pretty happy on Wednesday with some thoughts that we could see continued stimulus in the U.S., a so-called QE3.
I want to start by asking you, what is it exactly that the Fed is looking at to determine if they want to continue or expand stimulus? We heard from one of the Fed governors this morning about some factors that maybe were influencing his decisions. What are they looking at to determine this?
Johnson: They are using their overall economic forecast in a very general way, but they are looking at two things, and one would be on the growth side, and the other is on the inflation side. And they have to look at both pieces. They are trying to determine if the U.S. economy is slowing down or speeding up and what they can do to help accelerate that process.
And they look at a number of things. They clearly look at the employment report in a very, very big way, because they have the dual mandate of reducing inflation and managing employment. That's their explicit [mandate]. So, I am thinking they are going to watch the employment numbers very closely, and so after [last] Friday's disappointing employment report, clearly that got all the talk and the buzz really going about additional stimulus from the Federal Reserve.
Stipp: And I assume they are also looking at inflation data as well, because they are also explicitly managing inflation, and that has been milder in the recent past than we had seen last year.
Johnson: That's right. In fact, I just double-checked some of the inflation data, and we had a month of down, then last month was flat, and now the forecasts for ... next week's CPI report [indicate it] will actually be down another two-tenths of a percent. So, we are stringing together three months that will look like we are almost in a deflationary situation, and that will certainly help, because the Fed governors that have been very much against further easing have kept on citing inflation. And they still might say core inflation is the same as it's always been. But you know [what I say]: You can't eat "core." You've got to eat food and you've got to burn gasoline, and if those numbers are down, I think that will make people think they have a little bit more room to operate in terms of the Federal Reserve.
Stipp: If the Fed is explicitly looking at employment and also inflation, how does Europe factor into this? Are they looking at that situation in Europe, and is that having a role in whether they would decide to do more stimulus or not?
Johnson: Well, there is some disagreement there between a couple of Federal Reserve governors, and I think most of them are thinking maybe Europe might have more of an effect than they thought. Some of the [governors] who had been saying it made no difference at all are [now] even being a little bit more cautious about it.
One view has been that Europe is weak, and therefore we have to help. Another governor had the view that we could take interest rates to zero, we could take interest rates to negative, and Europe is still going to do whatever it's going to do; therefore we shouldn't do anything radical.
But there are others who view it as, let's help things along a little bit, and the U.S. consumer may help pull out Europe...
Stipp: ... by stimulating our own economy.
Johnson: [Yes,] our own economy.
Stipp: What are the tools available at the Fed's disposal? I believe one of the Fed representatives had mentioned Operation Twist on Wednesday morning.
Stipp: What is their arsenal right now, if they wanted to do a QE3 or continued stimulus?
Johnson: In the Fed's long-term history, their main tool for stimulating the economy was [managing] short-term interest rates, and then they hoped that long-term rates would naturally follow suit. That's always been their plan. They can directly, through bank deposit rates and ratios, control the short-term interest rate very explicitly.
And as those rates got pretty close to zero during the recession, then they had to find other tools. They wanted to directly bring down long-term rates because they couldn't bring down the short-term rates below zero. And so they bought bonds in that transaction, and they called it "Twist" because they started buying longer-term bonds, which they had never really historically done.
Stipp: We do know that we had certain stimulus measures that were taken [already]. Are any of those still ongoing right now, or have we basically reached the end of the stimulus that they had already planned?
Johnson: Well, the Operation Twist, the operation where they were buying longer-term mortgages, that program expires at the end of the June, and there was some thought, will they just keep rolling over what's there? Will they let stuff naturally roll off and the let the program go down? Or will they expand the program?
This morning, Lockhart, one of the Federal Reserve governors, said that based on what we are seeing in Europe, he would certainly be willing to consider that as an option if things got worse in the U.S. economy, at least renewing QE3.
Stipp: Two final questions for you, Bob: Do you think that it's likely the Fed will take additional stimulus? And then for you, personally, do you think that we need some kind of a QE3 program?
Johnson: I just have to wonder what they are going to think about QE3 or any type of further stimulus from the Fed, because it's essentially already happened. Interest rates in the last few weeks--part of it's been a flight to quality--but the benchmark that I use is 10-year Treasuries, and we started the year at 2% and the year before that, it was 3.5%. So we've gone from 3.5% to 2%, and right now we are in 10-year bonds at 1.5%. We got as low as 1.4% last week. I don't think anybody at the Fed is envisioning taking numbers any below that. The market has kind of already done it. It's just a matter of them reacting to it and validating some of what the markets have already come to the conclusion is going to happen.
Stipp: So, are you saying that there is not much the Fed could really do even if it wanted to?
Johnson: I think maybe they can say something about extending the Operation Twist--buying the mortgages--which is certainly a possibility. They may not let those mortgages burn off. People pay their mortgages every year, and one option is just to say, "OK, we've got one that ends, we just don't renew it. We don't cancel the program, but ... as the mortgages roll off, we let them roll off."
The other is, they take the money from the refinancings and go ahead and pour it into buying more mortgages, which I think is probably where they'll end up.
Stipp: So, putting aside the question of whether the Fed really has that much ammunition left or not, or how effective it could be at this point, when you look at the economy fundamentally, let's assume the Fed could pull a lever that would really offer a real stimulus, do you think we need it, though?
Johnson: I really don't think we need it. At least this time we haven't had the backdrop of asset prices booming, and therefore, every time they talk about QE3, we boost gasoline prices, we boost copper prices, and we kill the U.S. consumer.
Right now, the prices have really come down on oil, on gasoline, on cotton even, on copper. So, you go across almost any commodity--maybe there is an odd one here, maybe soy and maybe cattle are the only two that are anywhere even near the middle of their one-year price range--everything else is pretty much at the bottom.
So I'm not categorically [thinking further stimulus] is going to be terrible because we've already got prices that are near the upper end of the band, and this is just going to make corn prices and food prices go up. I'm not as categorically against it.
On the other hand, the markets have already taken care of it, as far as I'm concerned. I think rates are lower right now. I think that the consumer price index has come way back down, and that's going to be an automatic stimulus to the economy as we go on each month here and ... lower prices begin to roll through. I think that's going to give the U.S. consumer dramatically more consumption power. The 20% decrease we may potentially see over the medium term in gasoline prices is going to have a bigger effect than if every item that we ship to China went away.
Stipp: The consumer also has been pretty stable in their spending, so even if businesses are really being cautious right now, if the consumer is consistent with how they've been spending, businesses eventually won't be able to sit on their hands for too long?
Johnson: That's right.
Stipp: All right, Bob. Thanks for the insight on potential further stimulus, and for giving us some sense of the ramifications to that. Thanks for being here today.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.