Economists view the Federal Reserve’s communications with the public as being consistent over the last several weeks. There has been no change in the monetary policy outlook. The Fed had been expected to reduce the pace of asset purchases later this year. The financial markets, however, seem to be hearing different things at different times. Bernanke will have another chance to clear things up when he delivers his semi-annual monetary policy testimony to Congress this week. The markets will have another chance to misinterpret what he has to say.
The Fed’s detailed Summary of Economic Projections (attached to the minutes of the June 18-19 monetary policy meeting) showed that about half of senior Fed officials wanted to complete the asset purchase program (QE3) by the end of the year (not just reduce the rate of purchases), while others thought the program should continue into 2014. A compromise position would be to have the pace of asset purchases step down over time, with the timing and size of reductions driven by the economic outlook. If growth fails to pick up in the second half of the year as anticipated, then a reduction in the pace of asset purchases would be delayed.
Recall the Fed’s justification for QE3. In the September 13 policy statement, the FOMC noted that it was “concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.” The unemployment rate at the time was 8.1% (in August), having been in a narrow range (8.1-8.3%) since the beginning of the year, and (given appropriate monetary policy) was expected to trend down to 7.6-7.9% by 4Q13 (it’s currently 7.6%). In his press briefing last September, Bernanke noted that the labor market situation was “a grave concern” and said that “the idea is to quicken the recovery, to help the economy grow quickly enough to generate new jobs and reduce the unemployment rate.”
“‘Substantial’ is in the eye of the beholder. I think going from 8.1% (unemployment) and a stagnant rate of improvement (in GDP) to 7% and stronger economic growth is a substantial increase. I think it’s important to explain that we view ourselves as having two tools. One of them is rate policy, and that includes both setting the rate and providing guidance about future rates. That’s our basic tool, that’s the one that the Federal Reserve and other central banks have used forever. Asset purchases are a different kind of thing. They’re unconventional policy; they come with certain risks and certain uncertainties (sic) that are not necessarily associated with rate policy. So our intent from the beginning, as I’ve been very clear,was to use asset purchases as a way of achieving some near-term momentum to get the economy moving forward into a sustainable recovery. And then, essentially, to allow the low interest rate policy to carry us through.” – Bernanke, June 19
The purpose of the asset purchase program was to get the ball rolling, to provide some momentum to the overall economy. Having achieved that, the program would be scaled back and completed, at which point, a policy of low interest rates would continue to provide support for the recovery. Both the asset purchase program and the forward guidance on the federal funds target rate are meant to put downward pressure on long-term interest rates. These have been effective, as evidenced by the improvement in auto sales and housing activity. The labor market has improved, but remains far from being fully recovered – but a full recovery in labor market conditions was never the point of the asset purchase program. QE3 was never meant to have a long shelf life.
Of the Fed’s two extraordinary measures, the forward guidance is close to conventional monetary policy (low short-term interest rates). While there are some uncertainties associated with the forward guidance, the asset purchase program is a much different animal. Asset purchases could interfere with the normal functioning of the credit markets or generate risks to financial stability in general. All else equal, Fed officials would prefer not to have the Fed conduct large-scale asset purchases. However, most feel that the program has been necessary and the benefits have outweighed the potential costs.
The FOMC minutes show that some Fed officials were concerned that stating an intention to slow the rate of asset purchases, even if conditional on the economic outlook, “might be misinterpreted as signaling an end to the addition of policy accommodation or even be seen as the initial step toward exit from the FOMC’s highly accommodative stance.” Bingo.
It’s worth noting that the June FOMC meeting was led off by a discussion of “Guidelines for Policy Normalization.” The minutes showed that “although most Fed participants saw this as prudent longer-range planning, some felt the discussion was premature.” Yet, there was agreement that focus “continued to be on providing appropriate monetary accommodation to promote a stronger recovery and so judged that additional discussion regarding policy normalization should be deferred.”
Bernanke will have his work cut out for him this week, but he’s unlikely to say much that’s new. Over the last couple of months, there has been no change in the monetary policy outlook. Tapering the pace of asset purchases is not tightening. Short-term interest rates are expected to remain exceptionally low for a long time (well into 2015). The financial markets will have another chance to overreact, but the Fed chairman’s message is likely to further sink in. There will be two more employment reports before the September 17-18 FOMC meeting. These will likely have a very large impact on market expectations of what the Fed will do.
© Raymond James
