MacroScope

At the Fed, there’s a way to raise rates — but is there a will?

The Federal Reserve has kept its key federal funds rate at near-zero for four straight years, and it expects to keep it there for at least two more. But with each trip around the sun, outsiders wonder whether central bank policymakers will act without hesitation when the time finally comes to tighten monetary policy?

This week, the official with his hand on the Fed’s interest-rate lever, so to speak, asked that same question. Simon Potter, head of the Federal Reserve Bank of New York’s open market operations, was at NYU‘s Stern School of Business discussing the various ways the central bank can tighten policy: the federal funds rate; the interest rate on excess bank reserves; reverse repurchase agreements. Potter runs the unit that carries out Fed policy in the market, and sits in on most policy-setting meetings in Washington. Asked by a student about the inflationary or deflationary risks associated with tightening policy in the future, he had this to say:

The real heart of that question is a willingness one. I’m pretty confident we have the technical ability to raise rates. The hard part will be the willingness in some people’s minds. What I’ve seen among most people in financial markets is they’re pretty sure that the Fed will raise rates when it’s appropriate to do it… Definitely compared to 2009-2010, the type of hedge funds and people who took large bets thinking this would lead to high inflation have given up on that bet.

The trouble with the Fed’s calendar guidance on rates

Sometimes, communication can be the art of what not to say. Federal Reserve Chairman Ben Bernanke took pains this week to make clear that the central bank’s indication that it will likely keep rates low until mid-2015 does not mean it expects growth to remain weak for that long.

By pushing the expected period of low rates further into the future, we are not saying that we expect the economy to remain weak until mid-2015; rather, we expect – as we indicated in our September statement – that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

The comments speak to a key problem with the notion of calendar-based forward guidance, first adopted by the Fed in August of 2011: each time officials push the date further into the future, they risk dampening financial market sentiment, thereby having the opposite effect to the stimulus it intended.

How big will the Fed’s QE3 end up being?

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Polling data courtesy of Chris Reese

We’ll know it when we see it. That’s essentially been the Federal Reserve’s message since it launched an open-ended bond-buying stimulus plan that it says will remain in place for as long “the outlook for the labor market does not improve substantially.” Which begs the question: how much larger is the central bank’s $2.9 trillion balance sheet likely to get?

Minutes from the Federal Reserve’s October meeting point to solid support within the central bank for ongoing monetary easing via asset purchases well into 2013.

A number of participants indicated that additional asset purchases would likely be appropriate next year after the conclusion of the maturity extension program in order to achieve a substantial improvement in the labor market.

Yellen’s quiet revolution at the Fed

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Janet Yellen, the Federal Reserve’s influential Vice Chair and possible future replacement for Chairman Ben Bernanke, delivered an important speech this week. Entitled “Revolution and Evolution in Central Bank Communications,” Yellen traces the deep shift in sentiment towards the importance of policy transparency.

In 1977, when I started my first job at the Federal Reserve Board as a staff economist in the Division of International Finance, it was an article of faith in central banking that secrecy about monetary policy decisions was the best policy: Central banks, as a rule, did not discuss these decisions, let alone their future policy intentions. While the Federal Reserve is required by the Congress to promote stable prices and maximum employment, Federal Reserve officials at that time avoided discussing how policy would be used to pursue both sides of this mandate. Indeed, mere mention of the employment side of the mandate, even by the mid-1990s, was described in a New York Times article as the equivalent of “sticking needles in the eyes of central bankers.”

In her remarks, Yellen endorsed the concept of policy thresholds first championed by Chicago Fed President Charles Evans. Her backing suggests such numerical guideposts for policy – we’ll keep stimulating until jobs improve and as long as inflation doesn’t creep too far from the Fed’s 2 percent target – are effectively a done deal, though it remains unclear how quickly policymakers can agree on the details.

Fed’s Lockhart explains what he means by “substantial improvement” on jobs

Federal Reserve officials have linked their open-ended stimulus program to substantial improvement in the labor market. So now, it’s up to Fed watchers to hone in on a definition of substantial, no small task in a world of multiple and often conflicting indicators on the job market.

In a speech to the Chattanooga Rotary Club on Thursday, Dennis Lockhart offered some insights into how he’s thinking about the process:

For policy purposes, I think it’s appropriate to be cautious about relying on a single indicator of labor market trends—for example, the unemployment rate—to determine whether the condition of “substantial improvement” has been met. The official national unemployment rate published by the Bureau of Labor Statistics is the most prominent statistic in the mind of the general public. As a policymaker, I want to have confidence that a decline of this headline number is reinforced by other indicators and evidence of broad labor market improvement in its many dimensions. The challenge my FOMC colleagues and I will face is communicating in simple and trackable terms what this phrase “substantial improvement” means while respecting the complex reality of many moving parts. […]

Latin America: the risks of being too attractive

Ironically, an increase of capital inflows to Latin America in the last few years due to unappealing ultralow yields in industrialized countries and the region’s relative economic success is posing a threat for development, according to a recent paper that provides wider background to BRIC criticism of the latest U.S. Federal Reserve´s quantitative easing.

The article, written by Argentine economists Roberto Frenkel and Martin Rapetti for the World Economic Review – an international journal of heterodox economics –  warns about the possibility of a Latin American variant of the so-called “Dutch Disease”. This is a situation where a country suddenly finds a new source of wealth that makes its currency more expensive, hurting local exports and causing traumatic de-industrialization.

“Our concern is that massive capital inflows to Latin America may have pernicious effects via an excessive appreciation of the real exchange rates, which could lead to a contraction in output and employment in tradable activities with negative effects on long-run growth”, says the paper.

Housing neutral for Fed doves; Operation Twist running on empty

A slightly bigger than forecast 5.7 percent rise in sales of new homes in September reported by the National Association of Realtors on Wednesday lends credibility to September’s jump in housing starts, but appears neutral for Federal Reserve monetary policy discussions.

The jump in new home sales seems to have largely justified the 11 percent jump in September housing starts, says Decision Economics senior economist Pierre Ellis. The inventory of houses for sale at the end of September rose just 1.4 percent, from the end of August and the months’ supply fell to 4.5 months from 4.7 months, he added.

Thus, the increased production of houses seems not to have involved any “over-exuberant optimism” – and the impact if demand were suddenly to evaporate would be contained, he said. “Healthy skepticism seems to prevail in builderland,” Ellis observes.

Deciphering the Fed: Guideposts for progress on jobs

The Federal Reserve’s open-ended bond-buying stimulus announced last month was coupled with a promise to continue purchasing assets “if the outlook for the labor market does not improve substantially.” Central bank officials are expected to continue discussing what parameters they will take into account to define such progress, but are not expected to come to any hard and fast decisions just yet.

In a research note entitled “What the Fed didn’t say: Payrolls at 160K,” Torsten Slok, economist at Deutsche Bank, offers a few guideposts:

In terms of what the Fed will be looking at, we reckon that employment growth will be first among equals – in particular nonfarm payrolls. We estimate that the FOMC’s economic and policy projections are consistent with payrolls averaging gains of around 160,000 per month through mid-2015, when they have told us they expect the exit process to begin to get under way. There is a range of uncertainty around this estimate. But if the numbers are coming in well below that rate for a number of months (100k or less), look for the Committee to extend the mid-2015 date and possibly step up its QE purchases, and expect just the opposite if they are coming in well above that rate (200k or more).

Banks keeping most of QE3 benefits for themselves

Federal Reserve officials have been worried that their policy of ultra-low interest rates may be having less of an effect than usual because of a “broken transmission channel.” In plain English, this means the money hasn’t really been flowing smoothly from liquidity-flooded banks to would-be borrowers.

Economists at TD Securities argue banks have passed on less than half of their lower funding rates as reflected in yields on mortgage-backed securities onto consumers.

During the current iteration of monetary policy easing, pass-though peaked at 66% during the third week following the QE3 announcement, when MBS yields rebounded from their post-QE3 lows and 30-year mortgage rates fell to a record-low 3.36%. However, since the QE3 announcement, our calculations suggest that banks have passed through an average of just 40% of their lower funding rates (i.e. lower MBS yields) in the form of lower mortgage rates.

Why QE3 isn’t just for the 1 percent

During a Q&A at the Brookings Institution last week, former Fed Vice Chairman Donald Kohn asked new board member Jeremy Stein, formerly a Harvard professor, about the impression that the Fed’s quantitative easing was only helping wealthy people who benefit most from rising stocks.

“How do you deal with this sense that the effects of policy aren’t being equitably felt in all parts of society,” asked Kohn, who worked at the Fed for four decades before stepping down in 2010, and is now a Brookings Fellow.

Stein, who joined the Fed’s influential Washington-based board in May as a governor, suggested this was not an entirely fair accusation given the wide-ranging effects of the policy. Here’s how he explained it: