Fed hasn’t silenced markets, Williams says

February 15, 2012

Federal Reserve policymakers have long watched markets to gauge what investors think is in store for interest rates and the economy. Some – like former Fed Governor Kevin Warsh – have worried that the Fed’s unprecedented purchases of trillions of dollars of U.S. Treasuries and its long-term guidance on the future path of interest rates shuts off a key source of policy-guiding information. The Fed’s recent decision to publish policymakers’ interest-rate forecasts will make the problem worse, he predicted in a speech at Stanford University last month.

In some sense I have partially been made blind by these asset purchases. I, for one, consider financial markets an incredibly useful source of information. If the markets take the Fed’s projections and build that into their own, then the Fed won’t have a full set of gauges in front of them. The markets will simply be a mirror to what they say.

Now comes San Francisco Fed President John Williams with a research paper that argues, to put it bluntly, that Warsh is wrong – that markets are providing just as much information about expectations for Fed policy as they did in the days before the Fed had bought $2.3 trillion in long-term securities and began signaling short-term rates would stay low for years.

In the working paper co-authored with San Francisco Fed economist Eric Swanson and quietly posted to the San Francisco Fed’s website on Monday, Williams argued that five-year and 10-year Treasuries traders still respond with as much vigor to economic news as they did before the financial crisis. As Williams explained to reporters after a speech Monday at Claremont McKenna College:

We continue to see the markets reacting to information — they still give a signal for what they are thinking about when the Fed’s going to do (what), what policy is going to be, what they think of the future path of the economy. The markets are still working, they are still digesting the information, and they are still responding to it.

Williams’ paper also adds to research arguing there’s plenty the Fed can still do to help the economy, even with interest rates near zero for the last three years – and likely to stay there for another three. It’s a view that several of Williams’ colleagues, including Dallas Fed President Richard Fisher, have taken issue with, but one that Williams says his paper backs up. If long-term interest rates can rise and fall on unexpected economic news, as Williams and Swanson show in their paper, the Fed too can make its influence felt on long-term borrowing costs, the reasoning goes. The authors write:

Even when short-term interest rates are constrained by the zero lower bound, there may still be considerable scope for monetary policy to affect medium- and longer-term interest rates and, therefore, the economy. On several occasions since 2008, the Federal Reserve appears to have done exactly that, by managing private-sector expectations of future short-term interest rates and by conducting large-scale purchases of longer-term Treasury bonds and mortgage-backed securities.

No wonder Williams is holding the door open for further policy easing through asset purchases. Now we’ll just need to see if his fellow policymakers will listen.

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