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Dear Clients,

Please find attached our latest report, "Will the Federal Reserve Avoid Another Round of QE?"

Even though the March employment report was weaker than expected, the US economy should still grow by 2.5-3.0% in 2012. Additionally, monetary policy out of Europe and Japan could be more accommodative this year should adverse shocks befall either area.

Key conclusions to the report include:

• Despite a weak BLS employment report in March, strong ISM results and gains in hours worked guarantee that first quarter US GDP growth will be 2%-plus
• The two scenarios where QE3 becomes more likely for the Fed are another spike in gas prices or the Bush tax cuts expiring at the start of 2013
• Bundesbank opposition may prevent a third round of LTRO funding from the ECB unless there is clear evidence of a renewed downturn in the eurozone
• With the possibility of five new members on the Monetary Policy Board by the end of 2013, the BOJ could be entering an era of looser monetary policy
• Increases in bank lending will be the first sign that China is easing monetary policy

As always, we welcome any questions or comments.

Best regards,
David Hale
Chairman

David Hale Global Economics, Inc.

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Copyright 2012, David Hale Global Economics Inc. All rights reserved. This document is not for attribution in any publication, and you should not disseminate, distribute or copy this e-mail without the explicit written consent of David Hale Global Economics.

Will The Federal Reserve Avoid Another Round of QE?
By David Hale


KEY CONCLUSIONS
• Despite a weak BLS employment report in March, strong ISM results and gains in hours worked guarantee that first quarter US GDP growth will be 2%-plus
• The two scenarios where QE3 becomes more likely for the Fed are another spike in gas prices or the Bush tax cuts expiring at the start of 2013
• Bundesbank opposition may prevent a third round of LTRO funding from the ECB unless there is clear evidence of a renewed downturn in the eurozone
• With the possibility of five new members on the Monetary Policy Board by the end of 2013, the BOJ could be entering an era of looser monetary policy
• Increases in bank lending will be the first sign that China is easing monetary policy


WHY THE FED IS LIKELY TO AVOID A THIRD ROUND OF QE

It is unlikely the Federal Reserve will pursue another round of quantitative easing. The economy appears to have enough momentum to generate a growth rate of 2.5-3.0% this year. Core inflation appears likely to remain close to 2.0%. Unless rising gasoline prices depress consumer spending during the second quarter, the unemployment rate should continue to gradually decline. Fed Chairman Ben Bernanke may be impatient with the rate of decline, but he will find it hard to justify further quantitative easing if the economy is on a steady growth path.

There are several indicators which suggest the economy is improving. The ADP reported a job gain of 209,000 during March and an upward revision of 23,000 jobs during the two previous months. The manufacturing ISM index rallied a point to 53.4 in March. The production index rallied to 58.3 from 55.3. The em-ployment index rose to 56.1 from 53.2. Fifteen of the eighteen sectors surveyed reported growth during the month while an equal number reported an uptick in orders. The new orders data indicates that backlogs for durable goods industries excluding transportation were $386.4 billion in February, exceeding the previous record of $384 billion in July 2008. Record backlogs are being driven by two sec-tors—machinery along with electrical equipment, appliances, and components. The resilience of the backlogs suggests steady growth in business spending on new equipment. The non-manufacturing ISM index dipped to 56.0 in March from 57.3 in February, but the employment index rose from 55.7 to 56.7, and is now at its highest level in six years.

WAS THE MARCH EMPLOYMENT REPORT THE START OF A NEW TREND?

The outlier to this positive stream of data was the Labor Department's March employment report. It reported a job gain of only 120,000 compared to wide-spread expectations of a gain as large as 200,000 or more. The household survey also reported a job loss of 31,000 compared to gains of several hundred thousand during the previous months. The manufacturing sector created 37,000 new jobs. The private service sector created 90,000 jobs led by business services, health care, and leisure. The retail sector lost 34,000 jobs after a loss of 29,000 jobs in February. The construction sector lost 7,000 jobs after large gains in December and January. There was a decline of 8,000 in temporary workers after a gain of 55,000 in February. The government sector lost only 1,000 jobs after losing an average of 20,000 jobs per month during the second half of 2011. The diffusion index edged down to 59.6 from 60.7. The diffusion index for manufacturing rose to 67.9 from 59.9. The workweek edged down from an upwardly revised level in February, but aggregate hours worked in the first quarter rose 3.7% at an annual rate. The increase in hours worked guarantees that real GDP growth should be at least 2.0%.

The payroll proxy for private sector labor income slowed to only 0.1%, but be-cause of the 0.6% gains during the previous three months the first quarter gain was 5.8% at annual rates compared to 4.3% during the fourth quarter. The March employment data suggests that some sectors, such as construction and retailing, may have benefited from unseasonably warm weather during December and January. If that was the case, employment growth during the second quarter may average only 150,000 per month compared to 246,000 during the previous three months. There is clearly momentum in manufacturing and related business services while government is still a drag. The firmness of retail sales in February and March suggests this sector should not continue to lose jobs. The unemployment rate dipped to 8.2% because the labor force participation rate eased to 63.8% from 63.9%. The unemployment rate for all workers, including those involuntarily working part time, fell to 14.8% from 15.6% in February and 16.2% one year ago. The median duration of unemployment also declined from 20.3 weeks to 19.9 weeks.

The new positive for employment is greater optimism among small businesses. The latest employment report from the National Federation of Independent Busi-ness indicates employment per firm rose 0.22 during March compared to zero in January. This is the highest number since the recovery began in mid-2009. The percent of owners reporting that jobs are hard to fill declined to 15% from 18% in January. A decline in this number is often associated with reductions in plans to increase hiring. The NFIB survey therefore remains cautious about new hiring despite the improvement in recent months. One-third of the American labor force works in firms which employ fewer than fifty people.

In a recent speech to the National Association of Business Economists, Fed chairman Ben Bernanke downplayed recent employment gains by stating that the growth rate of GDP and GDI was still subdued. But shortly after his speech, the Commerce Department reported that real GDI grew by 4.4% during the fourth quarter. Since mid-2011, the growth rate of real GDI has been out pacing real GDP growth by a full percentage point. These two numbers often diverge for short periods of time, but the strength of real GDI does suggest that GDP growth may be understated. There will be data revisions in July which will clarify exactly what is happening.

The economy enjoyed healthy employment gains during the first quarter of 2011, but then lost momentum as rising gasoline prices depressed consumer spending and the Japanese earthquake disrupted supply chains in the auto industry. The large decline in unemployment insurance claims suggests that the job gains this year should be more sustained. The current level of claims is more than 40,000 below the level one year ago and more than 100,000 below their level in 2010. If gasoline prices continue to rise, they could jeopardize consumer spending during the second quarter, but so far they have been encouraging American households to buy more fuel efficient autos. Recent surveys of consumer confidence have been more upbeat despite rising gasoline prices because of better news about the economy and the rising equity market, but they could still jeopardize the recovery in consumer spending. The April retail sales data will be the first important sign of how gasoline prices are affecting the consumer.

The other constraint on the Fed pursuing a new QE program is the opposition of at least five district presidents in Dallas, Kansas City, St. Louis, Philadelphia, and Richmond. Only one of these presidents is currently voting, but all can express their views during FOMC meetings. It is doubtful that Mr. Bernanke would want to pursue a policy which faced such strong opposition. The Chicago president has expressed strong support for further QE while the New York president has not ruled it out, but the other presidents appear to be neutral on the issue.

There are two scenarios where QE could again become a Fed policy option. The first is that rising gasoline prices depress consumer spending and drive the econ-omy's growth rate back into the 1-2% range during the third quarter. There would be a sharp decline in job creation and the unemployment rate could tick up. The second scenario would be significant fiscal tightening in early 2013. Under current law, the Bush tax cuts and the payroll tax cut enacted in December 2011 will expire at year end. There will also be spending cuts resulting from last year's compromise on increasing the debt ceiling. If the White House and Congress cannot agree to extend the tax cuts, there could be fiscal drag equal to 3-4% of GDP starting in January. Such fiscal restraint could drive the economy's growth rate back to zero and compel the Fed to consider new measures to revive output. It will be impossible to forecast how Congress will behave until we see the election results. Republican victories will protect the tax cuts. If the Democrats hold the White House and gain in the Congress, they will attempt to raise taxes on high income people. Uncertainty about fiscal policy could depress spending during the fourth quarter.

The economy has had two other disappointing reports during the past few weeks. The January trade data suggests that the real trade deficit will increase during the first quarter and could depress output growth by as much 0.5%. The construction data for February was also remarkably subdued despite very benign weather conditions. Private nonresidential construction fell to $280.8 billion in February from a peak of $292 billion during December, but it is still 14.5% above its level one year ago. This weakness came after a 14% annual growth rate of nonresidential construction during the third quarter of 2011. The upturn in demand for architecture services suggests that nonresidential construction has bottomed, but it appears likely to recover at an erratic pace.

WAS THE SECOND ROUND OF LTRO FUNDING ALSO THE LAST?

The European Central Bank did not discuss further monetary easing at its latest meeting. The Southern European economies are clearly in recession, but Germa-ny's business confidence surveys have been more resilient, so the Bundesbank is probably reluctant to ease when inflation is still above 2.0%. The ECB also loaned over one trillion euros to European commercial banks during December and February. The ECB's intervention had a very tranquilizing effect on European financial markets, but the Bundesbank has been signaling that it does not want to do it again despite large-scale borrowing by German banks in the second round. If the European recession intensifies, Mr. Draghi could still ease, but he will need more clear cut evidence the downturn is affecting the core economies, not just the periphery.

IS THE BANK OF JAPAN ENTERING A NEW ERA OF LOOSER POLICY?

The Bank of Japan announced it would buy a further ¥10 trillion of government debt in February. A member of the monetary policy council has said that they might announce the purchase of ¥5 trillion more in April. There is growing political pressure on the BOJ to weaken the yen and end the country's deflation. Mr. Shirakawa has visited the diet fourteen times this year. The government named Ryutaro Kono, an economist at BNP, as a new member of the Monetary Policy Board (MPB), but he was rejected by the opposition parties in the upper house because he cautioned against an aggressive monetary policy. There is one other vacancy on the MPB and three more seats will become vacant during the next eighteen months. The term of Mr. Shirakawa will end in April 2013. If politicians insist on appointing highly dovish economists to the MPB, the preconditions might fall into place for a sustained depreciation of the yen. The Bank of Japan has been nominally independent since the late 1990s, but it is being subjected to unprecedented pressure to pursue an easier policy. If the bank now becomes highly politicized, it will be difficult to regard the yen as a safe-haven currency.

WHY AN INCREASE IN CHINESE BANK LENDING WILL BE A KEY SIGN

There have been signs of improvement in the Chinese economy during the past few weeks. The container freight index has been rising. There has been an in-crease in house purchases after a long period of decline. The corporate sector says that bank credit is becoming easier to obtain. The official manufacturing PMI rose to 53.1 in March from 51.0 in February. The HSBC PMI, by contrast, fell to 48.3 from 49.6. The official index was stronger because it is more heavily weighted towards large companies. The only bad news is that agricultural prices have begun to increase and could boost the CPI back towards 4% from 3.2% in February. The Chinese central bank has eased reserve requirements twice since December and will ease them again during the second quarter, but it is moving at a cautious pace because of lingering concerns about inflation and a desire to restrain the property market. The first confirmation that monetary policy is becoming more accommodative is likely to be an increase in bank lending after two months of subdued growth during early 2012. Premier Wen Jiabao has made a speech advocating radical changes in the banking system. The central bank has long been advocating interest rate liberalization, but it is not clear how rapidly the new leadership will move in accepting such proposals. The current system of regulation guarantees the banks wide lending margins while providing ample credit to the large state-controlled companies. They may be reluctant to accept changes which would produce more competition for bank deposits and divert more credit to small private companies. Small enterprises have been the most vulnerable to the recent lending squeeze and problems in the informal lending sector. Their PMI index fell 4.3 points to 50.9 last month while the large company index rallied 3.4 points to 54.3

AUSTRALIA WILL BE THE NEXT OECD COUNTRY TO EASE MONETARY POLICY

The next country likely to lower interest rates is Australia. The boom in the re-source sector is producing healthy GDP growth, but the strong dollar has penalized manufacturing, education, and tourism. There has also been a decline in credit growth, including mortgage lending. The slowdown in the non-resource sectors has reduced employment growth to 0.2% year on year in February from 3.9% year on year during November 2010. The market is discounting 75 basis points of rate cuts during the rest of 2012. The government's inflation report will determine whether the Reserve Bank eases as early as its next meeting in Apri