FED MOVE LIKELY BY JUNE, EX-INSIDER SAYS / BARRON´S ( HIGHLY RECOMMENDED READING )

Up and Down Wall Street
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WEDNESDAY, MARCH 7, 2012
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Fed Move Likely by June, Ex-Insider Says
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By RANDALL W. FORYSTH
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Morgan Stanley's Vincent Reinhart says central bank is apt to ease before election season hits high gear.

Odds of more monetary stimulus from the Federal Reserve seem to get longer as the economic data improve. And the Federal Open Market Committee is unlikely to take further action at its one-day meeting next Tuesday.




But a long-time observer of Fed policy—from the inside and the outside—thinks another round of quantitative easing, or other measures, is likely later this year. Vincent Reinhart, Morgan Stanley's chief U.S. economist, formerly was director of the Fed's Division of Monetary Affairs and served as the FOMC's secretary and economist, so he has seen things from both sides.




In his latest report, Reinhart writes there is a 75% probability the Fed will take some "unconventional action by June" because of the "political calendar." The central bank is supposed to be above the political fray, but this former Fed insider thinks Ben Bernanke & Co. will want to keep a lower profile in the second half of the election campaign season.




Secondly, the economics also will justify a move, he continues. (I may be naïve but I still find it jarring to list economics after politics in determining Fed decisions, but I'm not an ex-insider.) Economic slack (read "unemployment") persists and inflation remains below the Fed's medium-term projections, Reinhart notes.




Moreover, he notes the Fed sees risks the economy could slow. "Here, too, at Morgan Stanley, we share the view that the fillip to economic growth associated with a restock of inventories is fading and that real [gross domestic product] growth will slow notably in current quarter. Anxiety-inducing headlines that the economy is losing steam will be conducive to Fed action."




To be sure, expectations of QE3—another round of Fed securities purchases—or expansion of Operation Twist 2—the current program of extending maturities in the Fed's securities portfolios to lower long-term interest rates—have receded. While he admits labor market data have been stronger than he had expected, he adds: "The Fed's core policy makers, however, have sounded dovish in almost every policy utterance."




Similarly, Richard Koo, chief economist of the Nomura Research Institute, contends much of the recent strong data can be attributable to pent-up demand, especially for automobiles, but spending by middle-class consumers will continue to be hampered by falling house prices.



Moreover, he adds, Bernanke has warned of the "fiscal cliff" on Jan. 1 with the end of the Bush tax cuts and mandatory spending reductions agreed to in last summer's debt-ceiling brouhaha. And while Koo doesn't cite it, state and local governments face further belt-tightening beginning July 1, when most of their new fiscal years begin.




Bernanke's use of forceful language as "fiscal cliff," Koo writes, "highlights the extent of the Fed chairman's concern about this scenario." It should also be noted Bernanke has stressed the need to attain "sustainability" of the budget over the medium term, that is, a stabilization of the U.S. debt-to-GDP ratio which passed 100% last year.


.Morgan Stanley's Reinhart adds the Fed's emphasis "is on the dark clouds, not the silver lining." In particular, they worry about the fallout from the European sovereign-debt situation. "Deep down to their free-market bones, Fed officials are mostly euro skeptics who have trouble convincing themselves that a flawed currency union will survive," which is an interesting insider's take that doesn't come through their public utterances.



"A general piece of advice from Fed economists working on the policy challenges posed by the zero bound to the nominal funds rate is that it is best to front-load policy accommodation if there is a significant risk of an adverse event," he continues. And the Fed would rather do that before the election campaign gets into high gear.




But the notion needs to see a fall in economic activity before acting "is based on a misreading of the minutes of the January [FOMC] meeting," Reinhart asserts. A deterioration of their forecast or a slowing in the rate of expansion would be all that's required. Moreover, he adds, the Fed doubts inflation is a material risk.




All of which makes a three-in-four chance of either QE3 in the $500 billion-$700 billion range, or more Operation Twist 2 totaling $400 billion of Treasuries and agency mortgage-backed securities, offset by other reserve-draining operations. The latter could be approved as soon as next week's FOMC meeting or the April 24-25 confab. The last chance, in Reinhart's view, would be the June 19-20 meeting.




Of course, the best-laid plans of Bernanke & Co. were upset in 2008, when the financial crisis forced it to take dramatic action in the midst of the presidential campaign. It might be recalled that the presidential race was a virtual dead heat early that September coming out of the Republican convention. All that changed in the tumultuous weeks that followed. It is an episode surely nobody at the Fed would want to repeat.