Two of Morgan Stanley’s (NYSE:MS) most highly regarded economists, Vincent Reinhart and Matthew Hornbach, are saying that the likelihood of QE3 is over 50% chance. The economy has been showing some soft spots lately which has given some US investors the thought of another round of easing.
During a video presentation to clients, the two economists said the chances of QE3 were at 56%, with the sterilization coming in at 24%. Sterilization is essentially the Fed’s offsetting action such as selling assets that it holds, thereby leaving the monetary supply flat.
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Reinhart believes that we will see growing pressure on the Fed to take action in June. Here is what Mr. Reinhart said to his clients about the possibility of another round of easing:
“That means the countdown clock is ticking at the Fed because the closer action is to the election the greater is the risk that it is accused of attempting to favor the incumbent. That does not mean that the Fed would fail to act to significant economic deterioration in August through October, but it means that the bar for more tactical action will be higher and higher as we get closer to the election. Responding to deterioration in financial conditions is a tactical move, and if the Fed does not do so at the June 19 and June 20 meeting, the odds against it go up further.”
Hornbach touched on what the Fed could be buying in the event that another easing program does happen:
“We think the Fed will buy both treasuries and agency mortgage backed securities, tilting towards treasuries. Purchasing only treasuries risks disconnecting them from the rest of the fixed income market, and pushing term premiums on securities into more deeply negative territory. Purchasing MBS also gives some diversification and signals that official efforts to spur mortgage modifications are important. Our subjective assessment is that balance sheet action at the next meeting is 80 percent. There’s a 70 percent probability that it will be QE3 and a 30 percent opportunity that it will be a sterilizer program” (Businessinsider.com).
The part that puzzles me about all this is that how can you say you have a mathematical formula to see if the Federal Reserve will have another round of easing? It is a judgment call based on current economic conditions. If jobs continue to expand at a very slow rate and economic news continues to be bad, we may get another round of easing. However, the Federal Reserve is not relying on magical formulas to determine if they should start QE3.
Investors are cheering for QE3 which shouldn’t be, because another round of easing very well could jumpstart inflation. The thing that you need to worry about when there is a lot of easing, there is the possibility of higher inflation. A lot of big name investors are opposed to any sort of QE3 for this very reason. QE3 is more of a band-aid than a solution; in fact it could make the problem much bigger.
QE3 would make markets jump temporarily but at a certain point you need to ask “is it worth it?” The other bad news about another round of easing is that the Fed is running out of tools. Interest rates are still around zero, we have already gotten QE 1 and 2, reserve requirements are near extreme lows, etc. What is going to happen if conditions in the US continue to deteriorate?
The bottom line is that don’t hope for QE3. Easing is nothing but a temporary solution. The Fed’s next meeting is on June 20th and we will all be listening to see what the Federal Reserve wants to do now going forward.