• Upswing. After a long dry patch, the signs again point to recovery – in both the US and Germany. The recovery will, however, be little more than a (technical) rebound. The threat of setbacks is already looming again for the first half of 2010. That is stirring up memories of the doubledip recession at the beginning of the 80s in the US.

  • Double dip? We, however, do not want to go that far. While there are parallels – such as the inventory cycle and the oil price – a less actionist, anti-cyclical monetary policy should prevent a renewed backslide into recession. Since, however, credit will continue to be hard to come by and the private sector still has to clean up its balance sheets, we do not expect strong upward moves either. The "W" will therefore be much less pronounced than at the beginning of the 80s (p. 4-6 & chart below).

Friday Notes

  • Germany. Real GDP probably contracted marginally again in spring. There are, however, signs pointing to a tangible economic upswing in the second half of the year. We expect growth of up to 0.4% qoq (p. 7). For the first half of 2010, we expect growth of only 0.1%-0.2%.

  • US. We also expect a similar W-shaped recovery for the US. Reasons for the setback at the beginning of 2010 are replenished inventories and the end of fiscal policy impulses. Furthermore, there are signs of a new flash point with commercial real estate, which will hurt the economy, but primarily smaller and mid-sized banks (pages 8-10).

  • Further topics:

    – Weekly Comment: Exit strategy – ability versus willingness (page 2).

    – Data outlook: EMU economic climate continues to improve; US GDP to have contracted 1½% in spring (page 11).

    – Market outlook: Yields to rise again over the medium term; EUR will stay in demand (page 19).


Exit strategy: ability versus willingness

This week, Bernanke outlined clearly and convincingly the Fed’s exit strategy – the problem, however, is that it is not really a strategy but rather just a set of tools. In his testimony to Congress and in an OpEd piece in the Wall Street Journal, he argued that the Fed has all the instruments it needs to withdraw monetary stimulus when the time comes – while reiterating that monetary policy will need to remain expansionary for an extended period. I do not think this will suffice to allay the concerns of those who fear a resurgence of inflation. Investors do not doubt the Fed’s ability to tighten monetary policy – they doubt its willingness to do so in a sufficiently timely way. They know the Fed has the bullets, but fear it will not have the guts to pull the trigger. The root of these concerns, ultimately, is fiscal policy, not monetary policy: the fear is that the Fed might come under pressure to allow somewhat higher inflation in order to facilitate a reduction in the real burden of public debt. Moreover, these fears might be exacerbated by attempts to curb the central bank’s independence: Bernanke warned against extending the audit authority of the Government Accountability Office to monetary policy operations, flagging the risk that once the tightening cycle begins, Congress might require an audit of FOMC rate-increase decisions. The priority should be to outline a credible exit strategy for fiscal policy, not monetary policy – an exit strategy that should detail not just the instruments, but also the likely timing and conditions of their deployment. Without this, inflation concerns will eventually resurface. Fixed income markets reacted favorably to Bernanke’s commitment to keeping rates low for an extended period. Going forward however, long-term yields will again face upward pressures from a combination of inflation fears and recovery hopes. Inflation will not be a risk for some time, but inflation fears could still complicate the Fed’s job sooner than it would like.

Bernanke outlined the Fed’s exit strategy in a Wall Street Journal OpEd piece earlier this week, as well as in his testimony to Congress. He sought to reassure that the FOMC has the necessary tools to withdraw policy stimulus in a “smooth and timely manner” when appropriate. Bernanke’s OpEd explains how the Fed will deploy a combination of measures, including 1. increasing the interest rate it pays on reserves; 2. draining reserves through reverse repos; 3. offering term deposits to banks; and 4. selling long-term securities on the open market. This strategy would allow the Fed to raise market interest rates and limit the growth in money and credit aggregates once the financial system normalizes. (My colleague Harm Bandholz had already discussed the strategy in detail four months ago, see his piece in the March 27 Friday Notes).

Bernanke, however, hastens to add that, “Economic conditions are not likely to warrant tighter monetary policy for an extended period.” In other words, concerns about a possible resurgence of inflation are premature: the major expansion in the Fed’s balance sheets is only partly offsetting the ongoing deleveraging, so that money and credit growth are if anything still too slow. With unemployment and unutilized capacity rising, inflation is not going to accelerate.

In his testimony, Bernanke confirmed the Fed’s sober assessment of ongoing improvements in both financial and economic conditions, stressing the role of policy actions in unfreezing credit markets. He noted, however, that financial conditions remain stressed and credit difficult to obtain, and that the recent stabilization in household spending might prove shortlived, due to rising unemployment and still declining house prices. In the discussion, Committee Chairman Barney Frank highlighted the risks emanating from the commercial real estate sector (see this week's research note, too), and warned against the risk of a premature tightening of policy.

The rationale for outlining the exit path is clear: the Fed is still worried about the fragility of the recovery, while a number of market participants are already worried about inflation. If these concerns translate into rising longer-term yields, they might eventually undermine the recovery itself. The Fed therefore wants to reassure markets that it will be able to tighten policy when the time comes, so as to be able to maintain a supportive monetary stance for as long as necessary.

There is a clear risk, however, that this strategy will not work. In my view, markets do not doubt the Fed’s ability to tighten policy but rather its willingness to do so in a sufficiently timely manner. There are of course those who still fear a very mechanical relationship between the size of the central bank’s balance sheet and the rate of inflation. But for the majority of investors, inflation worries are driven by the concern that the Fed might not be tough enough to pull the trigger. These concerns, in turn, are partly driven by the large increase in the fiscal deficit and public debt: investors worry that the Fed might feel pressured into allowing somewhat higher inflation to facilitate the reduction of the government debt burden. The common wisdom is that the Fed, scarred by the historical experience of the Great Depression, tends to overweight growth concerns versus inflation concerns. Against this background, fears of political pressures can quickly take hold.

In this context, perceived attempts to reduce the Fed’s independence could exacerbate inflation concerns further. In his testimony, Bernanke warned against expanding the audit authority of the Government Accountability Office (GAO) to areas key to monetary policy, such as open market and discount window operations. The Fed’s role has become significantly bigger during the crisis and, as a consequence, more controversial. The risk of political pressure is clear, and it will be of paramount importance to preserve the central bank’s independence. During the discussion, Bernanke explicitly raised the risk that Congress might ask the GAO to audit an FOMC rate-increase decision once policy tightening gets underway.

The implication is that an exit strategy is much more urgently needed for fiscal policy than for monetary policy. Bernanke hinted at this in his testimony: he argued that policymakers must start planning now for the restoration of fiscal balance, especially in light of the looming rise in pension and health care costs linked to population aging, and concluded in very stark terms that “unless we demonstrate a strong commitment to fiscal sustainability, we risk having neither financial stability nor durable economic growth.”