The week in American monetary policy: Parsing the Federal Reserve
May 24th 2013, 18:39 by G.I. | WASHINGTON, D.C.
The Federal Reserve left a lot of people scratching their heads this week. Between Chairman Ben Bernanke’s testimony, and the release of the minutes to the May 1st Federal Open Market Committee, investors were struggling to figure whether an end to easy monetary policy was nigh. A headline in today’s The Wall Street Journal declares: “In Bid for Clarity, Fed Delivers Opacity.” Here is what I think is essential to understand about what the Fed is doing, what we learned this week, and why more crossed signals are likely ahead.
- The Fed has two exits to manage, not one. The Fed is stimulating the economy through two channels: quantitative easing, or QE, (the purchase of bonds with newly created money), and its zero interest rate policy, or ZIRP. It has different criteria for exiting the two policies. QE will end when the outlook for the labour market has improved substantially; ZIRP will end after unemployment has fallen to 6.5% or lower. In the Fed’s mind, QE will end a year or more before ZIRP. This, however, poses a monumental communications challenge because reasons the Fed gives for maintaining ZIRP sound like reasons to maintain QE, and reasons to end QE sounds like reasons to end ZIRP. In his written testimony, for example, Mr. Bernanke warned about a “premature tightening of monetary policy,” which was interpreted as meaning no change to QE. In fact, he meant no change to ZIRP. Thus, markets were surprised when, answering the first question from the Joint Economic Committee, he said, “in the next few meetings, we could take a step down in our pace of [bond] purchases.”
- Less stimulus is still stimulus. Many observers seem to think any reduction in the pace of QE constitutes tighter monetary policy. In fact, the Fed, like most economists, believes buying any quantity of bonds makes monetary policy more stimulative. So if QE were to slow from its current $85 billion per month to, say, $45 billion, policy would still be turning more stimulative; it would equivalent to cutting the Federal funds rate 5 basis points per month instead of 10. Only when the Fed’s balance sheet shrinks because it sold some bonds or allowed them to mature will it be tightening monetary policy. That, like an end to ZIRP, is probably two years away.
- Expected QE matters as much as actual QE. Now I’m going to offer a caveat to point #2. Because markets are forward-looking, bond yields respond to what investors expect the Fed to buy, not just what it does buy. So if the Fed signals QE will continue at a slower pace than investors expected, it will ultimately buy less than expected and yields should go up. That’s what happened this week. Minutes to the May 1st meeting show FOMC members perturbed that bond dealers (according to the New York Fed survey) expected QE to remain at $85 billion per month through year-end, an increase from the prior survey. This was viewed as inconsistent with an improving labour market and, apparently, what FOMC members themselves expected to do if the economy behaves as forecast. Part of Mr Bernanke’s job this week was to realign the market’s expectations with the Fed’s. Explaining the Fed’s reaction function, as this sort of guidance is called, has always been a key function of Fedspeak. But it was a more precise process in the old days when the Fed could see market expectations immediately reflected in Fed funds futures contracts. Until someone launches a futures contract linked to the Fed’s balance sheet, the Fed and investors will struggle to read each other.
- Wall Street is going to have some heart burn. If the Fed and the market have different expectations for the path of monetary policy, realigning those expectations is going to cause some breakage in the financial markets. If the market’s expectations get realigned in the direction of less stimulus, this unfortunately means bond yields go up, and monetary conditions tighten. That’s unfortunate but it will help the Fed refine both its communications and its policy stance. And it’s probably better the breakage occur sooner rather than later, when expectations may be even further apart.
- The exit from QE will not be predetermined. One of the main points Mr Bernanke tried to make was that if QE slows, it will “not be an automatic mechanistic process.” For example, if it drops from $85 billion to $65 billion, it need not drop to $45 billion at the next meeting. It could stay at $65 billion or if the data worsen, go back to $85 billion. This isn’t that surprising; the Fed always reserves the freedom to respond to the data and hates feeling boxed in by market expectations. Yet trying to get the market to believe the path isn’t predetermined is probably futile. After all, the Fed will slow QE according to its view of how the economy progresses. So long as that view is vindicated, there will be no reason to dial QE back up. When the Fed is finished it will look like a mechanistic process even if it wasn’t conceived that way.
- The economy is doing as well or better than the Fed expected. The terrible March jobs data provoked hand wringing everywhere but at the FOMC whose “participants generally saw signs of improvement in labour market conditions despite the weaker-than expected March payroll employment figure.” In his testimony Mr Bernanke noted the 6-month rate of job growth had risen from less than 140,000 to more than 200,000, without acknowledging it fell back below that pace in March and April. The reason for this upbeat tone is that economy has done a bit better than the Fed expected given the drag of higher taxes and the federal spending sequester. Neither the minutes nor Mr Bernanke’s testimony showed concern with the recent decline in core inflation, which they consider temporary. Note that this isn’t the same as saying the Fed is satisfied with the economy’s performance; it isn’t, and Mr Bernanke has gone hoarse imploring Congress to ease the vice of fiscal austerity. But changes to the stance of monetary policy are determined by how the economy performs relative to expectations, which currently incorporate America’s asinine fiscal policy. The bottom line: the economy and inflation are behaving in a way consistent with the Fed’s forecast and a tapering of QE later this year.
- Financial stability is a concern but not an obstacle. The cost/benefit analysis of monetary policy used to be binary: inflation vs. employment. Unconventional monetary policy, however, has a variety of other costs, and in remarkable admission, Mr Bernanke this week put financial instability, not inflation, at the top of the list. The Fed clearly shares some of the concerns of market participants that QE and ZIRP are fueling “reach for yield” in fixed income and equity markets, worsened underwriting standards, and an excessive appetite for risk. But saying financial instability is a cost is not the same as saying it’s a reason to halt monetary stimulus. The day will come when the aggregate costs of QE and ZIRP exceed the aggregate benefits but nothing in the minutes or Mr Bernanke’s testimony suggest that day is near. Indeed, the minutes show that only one of 19 FOMC members, presumably Esther George, president of the Kansas City Fed, thought financial stability was reason enough to taper QE now. QE will eventually taper, but more likely because the desired benefits have been achieved than that the costs have grown.
- Financial stability concerns may affect the composition but not the stance of monetary stimulus. While ZIRP fuels financial instability through “reach for yield,” QE conceivably does so more by reducing the supply of risk-free investments, thereby inflating the prices of riskier assets. Jeremy Stein, for example, has notedhow QE compresses the term premium (the additional bond yield investors demand in return for locking their money up). The Financial Stability Oversight Council and IMF both recently warned of a sudden rise in the term premium. Should worries about financial stability rise, the Fed may seek a way to reduce the pace of QE but offset the loss of monetary stimulus, perhaps by committing to maintain ZIRP for even longer.
- Expect more communications mishaps; don’t expect them to matter. The Fed has become steadily more transparent in the last two decades yet still regularly struggles to communicate. The more it says, the more there is to misinterpret. The potential for communications mishaps in the coming year is especially high because the Fed is juggling so many instruments and goals; this week was probably just a taste. That said, they are unlikely to matter. With time, the Fed always succeeds in making its policy clear. Getting that policy right has always been, and continues to be, the bigger challenge.