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It is widely expected that the Federal Reserve will announce more balance sheet expansion, or quantitative easing, on Wednesday. QE4 will consist of the Fed buying $85 billion in mortgage-backed securities and longer-term Treasuries at least to the end of next year, totaling at least $870 billion, according to Barclays.
The latest QE-program announced by the Bernanke Fed will be tied to the progress of the labor market, which has seen the unemployment rate tick down as a consequence of a falling labor participation rate, rather than truly improved economic conditions. This could mean the potential rate of output growth in the U.S. has taken a bit hit since the financial crisis.
A pretty strong consensus has formed among analysts and economists that the Fed will go full-steam ahead with its plans to deliver policy easing via balance sheet expansion. Specifically, after announcing open-ended purchases of mortgage-backed securities worth $40 billion a month in September, dubbed QEternity by the media, the FOMC is expected to unveil a new $45 billion plan to buy Treasuries in order to replace Operation Twist.
This means even looser monetary policy, as the Fed won’t be sterilizing the $45 billion that used to be part of the Twist. Chairman Ben Bernanke has been very clear about the need to provide continued support until he sees a real improvement in labor markets, and is putting his money where his mouth is: the Fed will have bought $870 billion in new securities from September to the end of 2013, according to Barclays, which expects Treasury purchases to end with June, while the MBS program should last to the end of the year. By the end of 2013, the Fed will own between 34% and 39% of the Treasury market across each sector of the curve, Nomura’s analysts noted.
How much is enough, though? The Fed has come under heavy criticism, particularly by Republicans, for its asset purchases, while the FOMC has been divided for some time, with the likes of Jeffery Lacker and Richard Fisher consistently dissenting with the committee’s decisions. Bernanke tried to shed some light on the issue, with the October FOMC statement noting:
The outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
The debate has raged on both within the FOMC and the broader academic and financial community. Indeed, there’s been talk of modifying the Fed’s forward guidance to include some measure of progress in the labor market, along with factors that take into account inflation. Analysts don’t expect any major breakthroughs in the Fed’s communication strategy on Wednesday, yet it is clear that simply looking at the unemployment rate doesn’t accurately measure progress on the jobs front.
Joblessness has ticked down 1.5 percentage points since the end of 2010, but only a portion of that is due to an improved economic environment, according to Nomura’s research team. A major factor pushing down the unemployment rate is the steady decline in the labor participation rate, which has fallen to its lowest levels since the mid-1980s. That’s clearly not a good thing.
As the unemployment rate has declined, it has actually worried economists that are seeing signs of a permanent reduction in the potential output of the U.S. economy. Citing Okun’s Law, which stipulates that for joblessness to slide real GDP must grow above potential, Nomura’s research team indicates that real output growth has averaged just under 2% annually since the end of 2010, meaning unemployment fell quicker than it should have.
The labor force participation rate, which peaked in 2000, has been trending lower ever since. Rising college enrollment, retiring Baby Boomers, and a topping out of the participation rate for women are all part of the explanation, but the decline has exceeded those demographic factors, Nomura’s team notes. This means these workers will probably return to the labor market as the economy improves, limiting that rate at which unemployment can fall.
Despite declining joblessness, firms are still announcing big rounds of job cuts. Over the past few months, companies like Boeing, Citigroup, Research in Motion, and PepsiCo have announced layoffs.
The Fed will therefore keep its QE programs alive until it can project above-trend GDP growth, Nomura’s research team argues. They see economic growth picking up in the second-half of 2013, indicating above-trend GDP projections won’t come in until then, at which point the Fed will begin to tone down its easing, first by halting Treasury purchases, and then by ending its MBS program.
