The Fed’s bad timing

By Felix Salmon
June 24, 2013

If you only read one article on US monetary policy and the latest actions of the Fed, it should be Wonkblog’s interview with St Louis Fed president James Bullard — an interview that answers pretty much every question you might have, with the exception of the “why did they do this” one.

Bullard — who was the sole dissenting dove at the last FOMC meeting — released a formal statement shortly afterwards, in which he explained that he is more dovish than the rest of the committee just because inflation is significantly lower than the Fed’s target. The statement explained:

President Bullard felt that the Committee’s decision to authorize the Chairman to make an announcement of an approximate timeline for reducing the pace of asset purchases to zero was a step away from state-contingent monetary policy. President Bullard feels strongly that state-contingent monetary policy is best central bank practice, with clear support both from academic theory and from central bank experience over the last several decades. Policy actions should be undertaken to meet policy objectives, not calendar objectives.

This is clearly the message that the market received, too. While the official message from the Fed was still state-contingent rather than based on the calendar, the FOMC did deliberately choose, at this meeting, to start talking about its economic forecasts and, in doing so, to start talking about exactly when (if the forecasts hold) QE might start tapering off.

Bullard has two problems with this. The first is that monetary policy is in large part an expectations game, and a key part of monetary easing, up until now, has been a concerted effort to move away from giving guidance on when monetary policy might change in the future. Now that the dates have reappeared, says Bullard, that unambiguously constitutes “tighter policy”.

Secondly, says Bullard, one of the reasons that central bankers tend to care more about inflation than they do about unemployment is that they have more control over inflation than they do over unemployment. But right now, inflation is going in the wrong direction: it’s falling, rather than rising towards the Fed’s inflation target. So this is not the time you want to start tightening policy.

The consequences of the Fed’s statement are profound. The Fed spent years trying to get control of long-term interest rates — but we’ve just seen a rise in those rates which was so sharp and dramatic that it has taken the breath away from even hard-bitten Treasury traders. To give you an idea of how fast things are moving, Paul Krugman’s column today talks scarily about how the yield on the 10-year Treasury bond rose from 1.7% two weeks ago to 2.4%, after the FOMC meeting. But that’s print deadlines for you: this morning, the 10-year is at 2.62% and rising, while stocks are continuing to fall.

The market turmoil is bad for wealth, of course: total global stock-market losses last week were more than $1 trillion, while the US bond market has lost almost as much. But more importantly, it’s bad for growth. If you want investment capital, you’re going to be raising either equity or long-term debt. And right now the cost of both is rising sharply: in the case of debt, it has risen more than 50% in the past couple of weeks.

David Reilly tries to make the case, today, that none of this is particularly worrying. The “Bernanke put” is an unhealthy thing: the Fed’s job is not, and should not be, to support stock prices. And when it comes to debt, says Reilly, just about everybody with market access has already taken advantage of incredibly low interest rates to lock in cheap funding. “if anything,” he says, “slightly higher rates might be good if they reduce the temptation for companies to engage in financial engineering by borrowing to pay out big dividends.”

Reilly isn’t even worried about the effect of rising interest rates on the housing market: “the prospect of rising rates,” he writes, “coupled with increasing home prices, may induce more buyers to come off the sidelines.” I’m inclined to agree on that front: the connection between mortgage rates and house prices is incredibly weak.

Still, even if we grant Reilly’s point that the Fed should ignore market noise and concentrate on its mandate, the FOMC decision to start talking about implementing tighter policy doesn’t really make sense. The latest Cleveland Fed estimate of 10-year expected inflation is 1.55%, very near the all-time low, and well below the Fed’s official target. And here’s the spread between the 10-year Treasury bond and the 10-year TIPS, which gives a day-to-day indication of what the market thinks inflation is going to be over the next 10 years: as you can see, it’s been falling of late to a decidedly un-worrying level.

With unemployment nowhere near the point at which wage pressures could create inflation, both of the Fed’s mandates are still pointing strongly towards loosening (if that were possible) rather than tightening. Reilly is right that QE is going to have to end at some point. But he has no good reason to believe that weaning markets off QE tomorrow would be harder than attempting it today. The market, for one, is telling him that in no uncertain terms.


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Bad timing — the Fed waited far too long to pop the bubble. The market action in May was obviously unhealthy, layering large gains on top of already inflated valuations. If they had taken cautious steps a couple months earlier, they could have avoided both the mini-bubble, and its reversal, and the slew of overreaction that has accompanied it.

The economy could perhaps use some targeted fiscal stimulus (higher taxes on the wealthy, higher spending on jobs/projects), but it doesn’t need any more QE. Withdrawal from that drug is surely painful, but it had to happen eventually. Better if it had happened BEFORE the markets drove up 20% in half a year on a weak economy and stagnant revenues.

Earnings have been increasing, modestly, but that is largely being driven by capital restructuring (borrow and buyback) and by cost-cutting. Neither is a sustainable replacement for top-line growth.

Posted by TFF | Report as abusive

Whenever stimulus is taken away people will say it is bad timing because it always causes pain and that pain is the thing they used to justify their argument that it was bad timing.

Posted by QCIC | Report as abusive

I guess the fundamental question is whether QE should end before or after real yields turn negative?

(Real) yields on the 20-year TIPS turned negative in April. Yields on conventional Treasuries were arguably already there. Following the May rally, stocks were priced for negative five-year returns (IMO, of course) in almost any economic scenario.

As frequently discussed here, QE can only do so much. It can’t reinvigorate an economy and it isn’t a substitute for sensible Federal fiscal policy.

Posted by TFF | Report as abusive

Funny how as soon as the Austerity pushers get their way “cut debt to keep interest rates down” interest rates go up!

See mainly macro for an interesting take on this: he-intellectual-bankruptcy-of.html

Posted by FifthDecade | Report as abusive

“That” vs. “Which.” I wish Felix Salmon would adopt the American style!

Posted by rmm2015 | Report as abusive