By Rom Badilla, Bondsquawk
Goldman Sachs’ Chief Economist, Jan Hatzius believes that given the weakness in the U.S. economy, additional monetary stimulus would be needed. However, the Federal Reserve faces significant hurdles in affecting the economy due to interest rates at historical lows. From Goldman Sachs’ most recent report, U.S. Economics Analyst, Hatzius suggests that the Fed still has tools at its disposal.
“Given sluggish growth and high unemployment, we believe further monetary easing will be needed. Our forecast of no rate hikes until late 2015 implies an additional lengthening of the committee’s rate guidance from the current “late 2014” formulation, and given our forecast for the economy—which remains below the Fed’s own view—we also expect additional balance sheet expansion by early 2013. But with interest rates already near historic lows, what can further monetary accommodation really achieve?
We believe that the objective of additional Fed easing would be to ease financial conditions beyond just pushing interest rates lower. Chairman Ben Bernanke, for example, said at the June 20 press conference:
‘I do think that our tools, while they are nonstandard, still can create more-accommodative financial conditions, can still provide support for the economy…’”
Hatzius provided a simple framework to Bernanke’s argument that the Federal Reserve is far from powerless:
“Changes in monetary policy, coupled with other financial shocks such as changes in risk premia, lead to changes in financial conditions. Together with other nonfinancial shocks such as fiscal policy or technological innovations, these lead to changes in real GDP growth, employment, and ultimately inflation. This suggests that in order to influence the growth rate of output and employment, and ultimately inflation, Fed officials would want to use their instruments to steer an overall measure of financial conditions.”
Hatzius offers evidence using statistical analysis to confirm that U.S. financial conditions which are measured by their in-house index, GSFCI, had been affected in response to both conventional and unconventional Fed policy action over a number of days. Conventional methods include interest rate cuts while unconventional policies involve non-traditional methods such as asset purchases, i.e. Quantitative Easing, changes to rate guidance, and rhetoric through major speeches by Chairman Ben Bernanke.
“Our analysis documents a systematic link between the Fed’s policy tools and the level of financial conditions. These results therefore support Chairman Bernanke’s view that the Fed retains tools to support the economy. However, our analysis also suggests that further use of these tools—even if aggressive—is unlikely to lead to a large improvement in the economic outlook. For example, our estimates imply that asset purchases of around $1trn would be needed to ease the GSFCI by 25bp. This suggests that purchases to the tune of QE2 (or $600bn) could be expected to ease the GSFCI by around 15 basis points and boost growth by ¼ point over the next year.
Given this, Hatzius argues that in order to make any meaningful impact in steering the U.S. economy, the Federal Reserve may need to go above and beyond what they have done in the past in the event growth turns for the worse.
Fed officials might therefore consider ways to make additional easing steps more powerful. One option would be to focus purchases on mortgages. Although the framework above is not well suited to distinguish between the effects of different asset purchase programs, we doubt that mortgage purchases would be meaningfully more powerful than buying more Treasuries. Another option would be to target corporate spreads more directly with a credit easing program along the lines of the UK’s “funding for lending” program. The main question about such a program, however, is whether the Fed could provide much stimulus through this channel without funding from Congress. We suspect the answer is probably no. The Fed’s “unconventional unconventional” options—including the Evans proposal and a nominal GDP level target—therefore deserve another look. Amongst these, we believe that a nominal GDP level target is the most promising. If the recovery remains weak, as we expect, these are likely to receive more attention, but they are still not part of our baseline forecast.”