December 15, 2010

FOMC’s Commitment to QE2 Is a Must for Markets, Analysts Say

$600 billion Treasury purchase should create jobs, nudge inflation higher

Analysts weighed in on the Federal Open Market Committee's (FOMC) decision Tuesday to move ahead with its $600 billion quantitative easing plan, saying the need for job creation in the United States overrides any other economic concern, especially since inflation is just a distant fear for now.

-- Jeffrey Kleintop, chief market strategist for independent broker-dealer LPL Financial in Boston, believed that repeating their message reinforces the Federal Reserve’s commitment to QE2 in the face of political pressure and their above-average targets for economic growth in 2011. And, he noted, the unemployment rate is higher now than it was at the time of the FOMC’s November meeting, while core inflation is lower and below 1%.

“This is a slight negative for stocks and Treasuries given the disappointment by some investors at the Fed not increasing their purchases to offset the added issuance in 2011 by the Treasury to fund the tax cut deal.  This does not change our views on the markets or economy, which is for modest growth next year. Clearly, the Fed likes to move at a deliberate pace. It is too soon for the Fed to alter the pace of QE2 which began to be implemented only six weeks ago,” Kleintop said.

-- Axel Merk, president and chief investment officer for Merk Funds, Palo Alto, Calif., said he has little doubt that the Federal Reserve will succeed in raising inflation expectations. The risk is that the Fed will get more than it is bargaining for.

“In the current environment, current inflation may be low, but future inflation expectations are not; until Fed Chairman Ben Bernanke's August speech, future inflation expectations were within historical norms. Since then, however, future inflation expectations have been moving up to levels we believe are not consistent with price stability,” Merk said.

-- Doug Roberts, chief investment strategist for ChannelCapitalResearch.com, Shrewsbury, N.J., was unsurprised by the FOMC’s stay-the-course announcement.

Roberts noted that Bernanke maintained his “usual pattern” of disclosing any new or potentially controversial moves in speeches or interviews rather than FOMC statements. Bernanke wants FOMC statements to be confirmations of the Fed’s existing positions, thus averting disruptions in the financial markets, Roberts said.

“The Fed will clearly maintain its easy money stance until employment improves substantially. The only item that might possibly change this is a substantial increase in inflation. This is consistent with the Fed’s dual mandate of price stability and full employment,” Roberts said.

-- Ian Shepherdson, chief U.S. economist for High Frequency Economics Ltd., in Valhalla, N.Y., also was unsurprised, but was ready for the Fed to reduce how much it spends on QE2. Though there are some tweaks to the language used to describe the economy, with household spending now said to be rising "at a moderate pace" compared to "gradually" in November, the changes are not significant, Shepherdson said.

“What is interesting, though, is that the statement implies that the Fed discussed whether QE2 should continue, just six weeks after it started: ‘... the Committee decided today to continue expanding its holdings of securities as announced in November.’ The discussion might have been entirely perfunctory but the fact that it happened at all suggests to us that if growth continues to pick up, QE2 is unlikely to reach the full $600 billion,” Shepherdson said.

What the FOMC Did on Dec. 14

The Federal Open Market Committee said in its Dec. 14 announcement that it still intends to buy $600 billion of longer-term Treasury securities—a second round of such buying also known as QE2—by the end of the second quarter of 2011. The FOMC also will keep the federal funds rate at its historic lows of 0% to 0.25%.

Long-term bond yields have stayed above the 3% level in December, contrary to FOMC expectations, with the 10-year Treasury note peaking at 3.46% in trading Tuesday after the QE2 announcement. In fact, interest rates from Treasuries to corporates to munis to mortgages are all now higher than they were before the markets began to discount the prospect of QE2.

In announcing its decision, the FOMC pointed to the nation’s stubbornly high unemployment rate of 9.8% and downward-trending inflation. But it showed no signs of acknowledging the recent congressional election victory of Republican deficit hawks or the bond market’s apparent determination to defy the Fed’s aim of easy money.

“Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the committee judges to be consistent, over the longer run, with its dual mandate,” the FOMC announcement said. “Progress toward its objectives has been disappointingly slow.”                

Read more about the FOMC’s Dec. 14 announcement at AdvisorOne.com.

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