What Is the Fed Thinking?

It is becoming harder to divine the thinking of the Federal Reserve. Recent behavior—particularly the two moves to taper the amount of quantitative easing—seem out of character with the Fed's earlier, much more tentative tone, especially since little in the economy has changed, certainly not enough to explain or even warrant this this more aggressive turn. Meanwhile, Janet Yellen, the new Fed chairwoman, would seem likely to lean toward more caution, not less. While a definitive reason for the change in thinking will not likely emerge anytime soon, a piece of research from the Fed's own staff may provide a hint, for it calls into question the whole rationale for quantitative easing in the first place.
Seeming Change at the Fed
There can be little doubt that the Fed’s tone has changed. Last spring, for example, then-Chairman Ben Bernanke announced that the Fed might begin cautiously to slow the flow of quantitative easing—"taper," in his words. His language was very tentative, and he qualified the plan by saying that the economic circumstances had to be just-so for the Fed to go ahead. Markets reacted poorly, anyway. During June and July 2013, the yield on 10-year Treasury bonds jumped by almost 100 basis points (bps).1 Stock indexes fell. But by August, markets had stabilized, and were ready for the Fed's active policy arm, the Federal Open Market Committee (FOMC), to start its taper when it met in September. But when the FOMC met, it decided to forgo even the first tentative steps toward the tapering. Consensus wisdom explained the caution in terms of Fed fears of renewed market turmoil or some underlying economic weakness about which only the Fed was aware, or a combination of the two.
Then, three months after this remarkable display of caution, the taper started. The FOMC announced in December 2013 its decision to buy $10 billion a month fewer Treasury and mortgage bonds than it had previously. Yet too little had changed in the economy to explain the move. There might have been slightly more optimism, but not the change for which the Fed said it was looking. The unemployment rate, for instance, had fallen slightly, but not because of new hiring; and anyway, it was still above the Fed's benchmark 6.5% of the workforce.2 There was some uncertainty surrounding the change in leadership from Bernanke to Yellen, but in December, he still sat at the head of the table. Then in January 2014, barely four weeks from the first taper move, the FOMC announced another step to slow monthly bond purchases, again by another $10 billion. Not only was there no change in the underlying environment between December and January but also there was not even enough time to weigh the impact of the first taper.
New Research
Only those on the FOMC, of course, can truly know the thought process behind this new eagerness to taper. But if the economic facts on the ground offer an insufficient explanation, a piece of Fed research might. Early last December, the FOMC received a remarkable study by two Fed economists, Steve A. Sharpe and Gustavo A. Suarez, titled, "The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs." It concludes that companies are unlikely to cut back much on capital spending if interest rates rise, even by as much as 100 bps, and they are even less likely to expand such spending if interest rates were to fall, even by as much as 100 bps.3 Since the whole point of quantitative easing was to stimulate business spending, and hence the economy, by reducing the cost of funds, the report must have given members of the FOMC pause. Certainly, it should have.
Of course, no single piece of research is ever conclusive. Still, this one is compelling, especially because it focuses on the period since the financial crisis and recession of 2008–09. Like all good scholars, Sharpe and Suarez's paper reviews earlier work in the field. It notes that these studies, which rely on time series data on interest rates and capital spending, find only a slight change in business behavior in response to interest rate moves. Other studies, which drill down to specific firms, find a slightly stronger relationship, but only slightly. Sharpe and Suarez's study approaches the matter differently from this earlier research. It relies on surveys, compiled by Duke University, of hundreds of CFOs in companies large and small across the country. These polls were made both before and after the rate increases in 2013.
If anything, Sharpe and Suarez find even less sensitivity to changes in yields and rates than did the earlier work. Only 8% of the respondents said they would increase this spending if the rates they face were to fall more by 100 bps and only 8% more said they would increase their spending if the rates were to fall in excess of 200 bps. Fully 68% said that they would not change the spending plans at all in response to interest rate moves, citing other factors, such as revenues growth and cash on hand, as more important. Rate increases drew only a slightly stronger response. Some 16% of the respondents said that they would reduce investment spending in response to a 100 basis-point rise in the rates they face, and another 15% said they would cut their spending for a rise of more than 200 bps—more sensitivity than they showed to rate declines, but still, hardly a powerful response.4
Since the main purpose of quantitative easing was to use rate and yield reductions to induce businesses to spend, and hence propel economic growth, these findings raise two significant policy doubts: 1) whether the Fed was right to initiate quantitative easing in the first place, and 2) whether a continuation of the program has promise of a favorable impact down the road. These results certainly strengthen the position of those on the FOMC who have doubted the program throughout. The Fed may be especially sensitive to these conclusions and the doubts they raise because it also is well aware that quantitative easing, whatever else it might do, carries considerable risk. Several members at the Fed, including Bernanke, have noted the possibility that quantitative easing could breed asset bubbles, such as developed from past, and less radical, easy monetary policies in the late 1990s and during the years 2005–07. Others have noted how excess flows of liquidity also led to generalized inflationary pressures, something the Fed definitely wants to avoid. Against such concerns, the research effectively warned the FOMC that its quantitative easing program was incurring risk with little or no chance of the reward policymakers sought.
No doubt, the report could not sway policy on its own. But given the tension over quantitative easing already in the FOMC and the clear longer-term risks of which all at the Fed are well aware, it may well have had an outsized impact and, so, go a long way to explaining the Fed's new eagerness to taper, even though little in the underlying economic fundamentals has changed since last year. It points, all else equal, to a measure of tapering at each FOMC meeting going forward.
1 Data from Bloomberg.
2 Data from the Department of Labor.
3 Steve A. Sharpe and Gustavo A. Suarez, "The Insensitivity of Investment to Interest Rates: Evidence from a Survey of CFOs," Federal Reserve, December 2013.
4 Ibid.
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