The other big question at Jackson Hole

August 22, 2013

It will be a tough one to avoid. Federal Reserve Chairman Ben Bernanke’s absence from Jackson Hole is just one in a series of strong hints he will step down at the end of his second term in January. So, it is only natural that a lot of the talk on the sidelines of this year’s conference will inevitably revolve around the issue of his replacement.  

But there is another, potentially more important question that needs to be answered in the shadow of Wyoming’s majestic Grand Teton peaks: Why have top U.S. Fed officials, even dovish ones, become increasingly queasy about asset purchases despite falling inflation?

Thus far, policymakers have discussed the prospect of a reduction in the pace of their bond-buying stimulus in terms of an improvement in the economy and the prospect of an even brighter outlook toward year-end and in 2014. Yet the U.S. economy, while outpacing its even more anemic rich-nation counterparts, is hardly besieged by runaway growth of the sort that would normally lead central banks to tighten monetary policy. And by even talking about reducing bond buys, the Fed has helped push interest rates up more than a full percentage point, to a two year high, in just a few months.

There are a number of possible explanations, and the reality likely combines some element of each. One, sadly, is politics. As much as the central bank likes to tout its independence, policymakers were clearly caught off guard by the blowback, both in Congress and among the public, to unconventional monetary policy. The perception that the Fed was acting recklessly, even if erroneous, was relatively widespread, even among some respected voices in the economics community.

A second, likely more salient issue for Fed officials is the prospect that their asset purchases could adversely affect financial markets in some way. This could happen if the prolonged period of low rates stokes asset bubbles. This concern has prompted Kansas City Fed President Esther George to dissent against the Fed’s decisions so far this year to maintain stimulus levels steady. Jeremy Stein, an influential board governor who may have some intellectual sway with Bernanke and others, highlighted risk  to financial stability from ongoing asset buys in a speech earlier this year.

A number of U.S. central bankers including Bernanke have expressed relief about the possibility that the recent back-up in interest rates reflects a healthy removal of froth for a market that had grown complacent about risks. Never mind that the whole point of quantitative easing was to prompt businesses to take risks in the first place.

Then there is the issue of efficacy. Is the bond buying having a beneficial economic impact? Here, the Fed itself appears to be changing its mind on the matter. Just last year at Jackson Hole, as the central bank began to lay the groundwork for a third round of quantitative easing, Bernanke touted the benefits of asset buys with a palpable sense of conviction.

The Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points. Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.

Yet more recently, despite a job market that remains subpar by most accounts and inflation that remains well below the Fed’s target, the chairman has tended to focus on the positive in making the case for wrapping up a five-year run of unconventional monetary policy.

The economic outcomes that Committee participants saw as most likely in their June projections involved continuing gains in labor markets, supported by moderate growth that picks up over the next several quarters as the restraint from fiscal policy diminishes. Committee participants also saw inflation moving back toward our 2 percent objective over time. If the incoming data were to be broadly consistent with these projections, we anticipated that it would be appropriate to begin to moderate the monthly pace of purchases later this year.

And if the subsequent data continued to confirm this pattern of ongoing economic improvement and normalizing inflation, we expected to continue to reduce the pace of purchases in measured steps through the first half of next year, ending them around midyear. At that point, if the economy had evolved along the lines we anticipated, the recovery would have gained further momentum, unemployment would be in the vicinity of 7 percent, and inflation would be moving toward our 2 percent objective. Such outcomes would be fully consistent with the goals of the asset purchase program that we established in September.

Which brings us to the issue of timing. When Bernanke laid out this-market-spooking roadmap to tapering at his June press conference, sending Treasury yields sharply higher and emerging markets steeply lower, it was hard not to wonder whether the chairman didn’t feel a sense of responsibility in wrapping up his unconventional policies at the end of his second term. Still, given Bernanke’s repeated warning about the dangers of a premature policy tightening, it is hard to imagine that the chairman would not change his mind if the second half rebound the Fed has been banking on fails to materialize.

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