The Federal Reserve speaks: Fearful symmetry

May 1st 2013, 21:45 by G.I. | WASHINGTON, D.C.

THE Federal Reserve, as widely expected, stood pat today, reaffirming its commitment to near zero interest rates until unemployment fell to 6.5% or lower, and continuing to buy $85 billion of Treasury and mortgage-backed bonds until the jobs market improved substantially.

But its otherwise ho-hum statement jolted markets with this new line: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.”

The wording was scrupulously symmetric; QE could rise, or fall. Yet stocks took the news quite badly. It recalled the Frost Report Monty Python sketch starring John Cleese in which two bored airline pilots decide to rattle their passengers by announcing to the cabin, “There is absolutely no cause for alarm.”

Why would the Fed take the trouble to make explicit something that was already implicit in the statement? It helps to go back to the March meeting when Ben Bernanke, in his post-meeting press conference, first broached the possibility of changing the pace of quantitative easing (QE, the purchase of bonds with newly created money) from $85 billion per month: “As we make progress towards our objective, we may adjust the flow rate of purchases month to month to appropriately calibrate the amount of accommodation we’re providing given the outlook for the labor market.” The wording was symmetric but the intent seemed asymmetric as Fed officials began talking about when they’d taper purchases, not ramp them up. On April 3rd John Williams, who is president of the San Francisco Fed and a good proxy for the overall Federal Open Market Committee, said

Assuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer.  If that happens, we could start tapering our purchases then.  If all goes as hoped, we could end the purchase program sometime late this year.
That theme was reinforced by the minutes to the March meeting which reported that many officials, “including some of those who were focused on the increasing risks, expressed the view that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings.”

Thus, officials were coalescing around the idea that QE would draw to a close around year end. But on April 5th the economic outlook took a turn for worse with the release of weak March jobs data. Almost every economic report since has been disappointing. Fed officials thus entered this week’s meeting with cross-cutting pressures: an underlying view that QE should start to taper off soon; and economic data that undermined the case for such a tapering. The sentence the Fed added to this week’s statement was a reminder to the market that the fate of QE is tied to the fate of the economy, and tapering is not a done deal if the economy doesn’t hold up its end of the bargain.

Nonetheless, the mere assertion that QE is symmetric is, in effect, asymmetric. The economic data have been disappointing and core PCE inflation has fallen to 1.1%, well below the Fed’s target of 2%. This is not likely a precursor to deflation since neither CPI inflation nor inflation expectations are behaving the same way. Nonetheless, developments on growth and inflation would ordinarily argue for a bias to raising, not lowering, QE. But an increase in QE is unlikely, for two reasons. First, as long as the Fed is expanding its balance sheet, i.e. so long as QE is above zero, monetary policy is getting easier. The Fed would regard $85 billion a month as a relatively aggressive effort to bolster demand, akin to cutting the Federal funds rate a bit more every month.

Second, outsiders routinely ignore the sentence in every FOMC statement that QE will depend on its “likely efficacy and costs”, but they shouldn’t. Officials are increasingly sensitive to the costs of prolonged zero interest rates and QE. The annual report of the Financial Stability Oversight Council, of which the Fed is a member, warned last week that a “sudden spike in yields and volatilities could trigger a disorderly adjustment, and potentially create outsized risk.” No matter how strongly a central banker believes in the benefits of QE, a balance sheet expanding by 6% of GDP per year is going to make him or her ever more sensitive to the unintended consequences. The Fed looks caught between an economic outlook that calls for more QE and a cost-benefit equation that calls for less. The result, for the time being, is it will remain on course.

The original article is linked here.