MNI EXCLUSIVE: Inflation Retreat Could Prompt Fed To Expand QE

Another outbreak of financial market tension could prompt the Federal Reserve to step up quantitative easing, but reluctance among some policymakers to add bond purchases to forward guidance on rates last month indicates a high bar for further monetary accommodation, current and former Fed officials told MNI.

For the moment, the Fed is prepared to wait until after November's elections to see if output and inflation expectations hold their ground, the sources said, speaking before President Donald Trump indicated he was suspending talks on further stimulus.

"The framework's been set, the goals have been set, the operating rules have been set," said Alberto Musalem, former executive vice president at the New York Fed and now at Evince Asset Management. The outlook isn't likely to change between now and November, but if financial conditions tighten as a result of the election, "then you might imagine that they might also enhance the forward guidance to also include the balance sheet in it," which would imply more QE for longer.

The recent change to rates guidance "no doubt involved a fair amount of give and take among various members of the FOMC. Reopening this agreement, at least without a marked change in the outlook, would at a minimum be complicated," said Nathan Sheets, a former top Fed and Treasury official, now chief economist at PGIM Fixed Income. "That said, the forward guidance on asset purchases that the Fed provided was substantially weaker than its other policy initiatives. If the recovery weakens a notch, a strengthening of this language strikes me as the most likely change."

BLEAKER OUTLOOK

Tuesday's sudden halt to stimulus talks came as a surprise, but Fed officials don't expect the lack of imminent aid to derail the recovery on its own. Small businesses and low-income earners, who benefited most from USD3 trillion in aid at the start of the pandemic, still need direct assistance, policymakers say, but whether that support comes before the election or some time next year won't matter so much as the trajectory of the virus.

"I do expect some additional fiscal support. The timing of that is unclear," San Francisco Fed President Mary Daly told MNI last week. "If we get less fiscal support, or if we don't get a package at all, it would be a slower path to full recovery. How much it slows will be dependent on how fast we get the virus under control."

Given the number of moving parts affecting public health and the economy, "the world might look quite different by December, and there might be some actions to take," including offering more forward guidance on QE, signaling a reconsideration of yield caps or making other changes to the asset purchase program, former Atlanta Fed President Dennis Lockhart told MNI.

INFLATION SLIPS

The FOMC could take forceful action if inflation or inflation expectations, especially over the longer run, move down, sources said.

The Atlanta Fed's survey-based measure of firms' expectations for inflation in the year ahead fell to a series-low 1.4% in April from around 2% prior to the pandemic before recovering to 1.6% last month. But expectations for inflation over the next five to 10 years appear more stable, ticking down by just 0.2 pp to 2.4% in September from March.

"Firms haven't seen in this pandemic something that will change their cost structure over the very long run, but it's something we're monitoring," Atlanta Fed economist Brent Meyer told MNI. "If they thought this was something that was going to permanently damage the economy, I think you'll see long-run expectations dip lower and that would be very concerning because that would mean firms are no longer planning and engaging for a period of time when we're beyond this."

Analysts expect that an increase in the Fed's pace of asset purchases could raise inflation expectations, noting that 10-year breakeven inflation gained roughly 1 pp during the second round of QE in late 2010 and early 2011.

The FOMC last month pledged to continue buying at least USD80 billion of Treasury securities and USD40 billion of agency mortgage-backed securities a month to ensure markets function smoothly and maintain accommodative financial conditions.