The Federal Reserve should consider delaying the end of its bond-purchase program to halt a decline in inflation expectations, said St. Louis Federal Reserve Bank President James Bullard.This is the most important event during this wild and volatile week. Why? Because the Fed is basically telling market participants it is very worried about Europe's deflation demons spreading to the United States and elsewhere.
Bullard, who helped lay the intellectual groundwork for the Fed’s quantitative easing program, said U.S. economic fundamentals remain strong, and he blamed recent financial-market turmoil on downgrades in the outlook for Europe.
“Inflation expectations are declining in the U.S.,” he said in an interview today with Bloomberg News in Washington. “That’s an important consideration for a central bank. And for that reason I think that a logical policy response at this juncture may be to delay the end of the QE.”
Bullard is the first Fed official to publicly suggest the central bank should extend its asset-purchase program when policy makers meet later this month. U.S. stocks erased losses and Treasury yields rose on expectations the Fed will take action to insulate the U.S. from global economic weakness.
“We are watching and we’re ready and we are willing to do things to defend our inflation target,” Bullard said.
Fed officials are scheduled to next gather on Oct. 28-29 and have said they expect to end asset purchases after that meeting. The program has already been wound down to combined monthly purchases of $15 billion of Treasuries and mortgage backed securities, from $85 billion in December 2012.
Committee Intentions
“Fifteen billion by itself is not that consequential,” Bullard said. “But what is consequential is committee intentions on future QE, and we have certainly seen through the taper tantrum how important those can be.”
He was referring to an episode last year when Treasury yields shot up after then-Chairman Ben S. Bernanke said the Fed would start slowing bond-buying sooner than expected.
Bullard said he continues to forecast the first Fed interest-rate increase at the end of the first quarter, based on the expectation that the current global market turmoil won’t affect U.S. prospects. Economic growth could be bolstered by declines in oil prices and long-term interest rates, he said.
A pause in tapering would protect against “downside risk” and bolster inflation expectations, he said. “We could react with more QE if we wanted to.”
The Standard & Poor’s 500 Index (SPX) rose 0.4 percent to 1,870.25 at 1:37 p.m. in New York after dropping as much as 1.5 percent. U.S. 10-year Treasury yields rose two basis points, or 0.02 percentage point, to 2.16 percent.
Bullard Paper
Bullard, who doesn’t vote on policy this year, has been seen as a bellwether because his views have sometimes foreshadowed policy changes. He published a paper in 2010 entitled “Seven Faces of the Peril,” which called on the central bank to avert deflation by purchasing Treasury notes. That was followed by a second round of bond buying.
“Bullard is a very practical voice at the Fed, and changes in his views often reflect the swing in the balance of risks in the economy,” said Mark Vitner, senior economist at Wells Fargo Securities LLC in Charlotte, North Carolina.
“The Fed is highly attentive to the outlook for the economy, and the outlook for the global economy has deteriorated,” Vitner said. “Inflation looks like it has decelerated and may decelerate further.”
Stocks, Oil
The 10-year Treasury yield fell below 2 percent yesterday for the first time since June 2013 as weaker-than-forecast economic data added to concerns that economic growth is slowing. That worry has helped push down stocks, oil prices, and measures of inflation expectations, while increasing the value of the U.S. dollar relative to trading partners.
The Fed aims for 2 percent inflation, as measured by the personal consumption expenditures price index, which was 1.5 percent in August and hasn’t exceeded 2 percent since March 2012. Expectations of future inflation, which are important because they can affect spending by businesses and households, have dipped in recent months alongside a decline in oil prices.
A Bloomberg measure of market forecasts for average inflation over the next five years was 1.49 percent at 1:41 p.m. in New York, compared with 2.1 percent in June.
The Fed has said its policies are dependent on evolving economic data as it seeks to steer the economy to full employment and stable prices.
“I am saying today that maybe we should invoke the data dependent clause on the tapering,” Bullard, 53, said. “I think that is our simplest step that we can take in this circumstance.”
On the other hand, he said U.S. economic fundamentals remain strong, and he hasn’t downgraded his forecast for growth of 3 percent or more in the second half of 2014 and 2015.
“The hard data on the U.S. is good,” he said. “The last jobs report was quite strong.” The jobless rate fell to 5.9 percent in September, and payrolls expanded by 248,000.
The most important thing Bullard said yesterday during this Bloomberg interview was this: “We could react with more QE if we wanted to.”
Now think about it. You've got Mario Draghi who is constantly being warned by German leaders not to engage in massive quantitative easing, effectively limiting the European Central Bank's response to fight deflation in the eurozone.
What Draghi is proposing is some form of asset purchases but these measures are considered cosmetic, which is why shares in Europe plunged earlier this week before rallying once markets caught wind that the Fed is standing ready to move.
And European bank shares led the late week rally after selling off strongly earlier this week. Why? Because if the Fed delays its tapering, or engages in more QE, it will basically aid them into shoring up their weak balance sheets. They can basically buy U.S. bonds, lock in the spread and improve their liquidity.
The Fed is basically telling Europe's big banks: "Don't you worry about Angela Merkel,Wolfgang Schäuble, and the lack of major QE from the ECB, if they don't act, we will act in a forceful manner allowing you to use our balance sheet to shore up yours."
And that ladies and gentlemen is huge news for markets because it basically sends a strong message to short sellers salivating at the prospect of a eurozone collapse that the Fed isn't about to stand by and let it happen. Why? Because a eurozone collapse will unleash those deflation demons and ensure the U.S. and rest of the world are heading for a protracted period of debt deflation.
Even the threat of more QE from the Fed is enough to send shivers down short sellers' spines, which is why you will likely see risk assets rallying during the second half of October. Pay attention here to the ten-year Treasury yield (^TNX), the euro/USD exchange rate, crude oil prices, and small cap stocks (IWM) which have led the rally out of the selloff earlier this week.
As far as stocks, I've said it before, the real risk in the stock market is a melt-up, not a meltdown. We're going to get a massive liquidity rally unlike anything you've ever seen, then you'll need to worry about the massive hangover and protracted debt deflation, which remains my ultimate endgame.
In this environment, you have to pick your spots carefully or risk getting slaughtered in the stock market. I would steer clear of energy (XLE) and materials (XLB) which are prone for more weakness ahead. They're bouncing back after suffering steep losses but use any rally to shed your positions here.
I continue to favor small caps (IWM), technology (QQQ) and biotech shares (IBB), including smaller biotechs (XBI) that have sold off lately. These are extremely volatile and risky but there is a great secular story here that will play out for many years to come. Keep an eye on companies like Idera Pharmaceuticals (IDRA), Biocryst Pharmaceuticals (BCRX), Progenics Pharmaceuticals (PGNX), Synergy Pharmaceuticals (SGYP), Threshold Pharmaceuticals (THLD), TG Therapeutics (TGTX), XOMA Corp (XOMA). I would take advantage of the latest selloff to add to some of these biotechs. I also like Twitter (TWTR) and see a bright future for this social media stock.
What's the biggest risk to my scenario? A deep crisis of confidence if the Fed actually does engage in more quantitative easing and market participants think they're way behind the deflation curve. That's the scenario that keeps James Bullard and Janet Yellen awake at night but for now, I wouldn't worry about any deep crisis of confidence.
Below, Federal Reserve Bank of St. Louis President James Bullard talks about monetary policy, U.S. economic fundamentals and the global economy. Bullard, speaking with Michael McKee on Bloomberg Television's "Market Makers." Take the time to listen to this interview, it's by far the most important market event of the week.