MacroScope

Revenge of the Fed hawks – sort of

Gabriel Debenedetti contributed to this post

Federal Reserve officials appear to be getting cold feet. Having just announced an open-ended bond buying program in September and then broadening it in December, minutes from last month’s policy meeting suggested an increasing caution about additional monetary stimulus among the Federal Open Market Committee’s core of voting members.

Several (members) thought that it would probably be appropriate to slow or to stop purchases well before the end of 2013, citing concerns about financial stability or the size of the balance sheet.

That’s considerably quicker than investors had in mind. Stock and bond markets recoiled at the prospect.

Many analysts noted key figures like Chairman Ben Bernanke and his number two and potential successor Janet Yellen have often spoken out in favor of QE and argued Fed policy is having a positive effect. Says Eric Stein at Eaton Vance in Boston:

I still think the core of the FOMC will be very aggressive on the monetary easing side unless they are fully convinced that we are in a strong sustainable recovery or there is a significant pickup in inflation.

Does the Fed need a new mandate?

Are the world’s top central bankers too paranoid about inflation? As the United States struggles to sustain a weak recovery while the euro zone and Japan face outright contractions in output, a number of economists have called for the monetary authorities to be less dogmatic about adhering tightly to low inflation targets.

Most prominently, IMF chief economist Olivier Blanchard has argued the Federal Reserve’s 2 percent inflation target is too low given the severity of the loss of employment and growth that followed the Great Recession of 2008-2009. Kenneth Rogoff, co-author of an oft-cited study of economic downturns following financial crises called “This Time is Different,” has also championed greater inflation tolerance.

Fed officials, including Chairman Ben Bernanke, have flatly declined to entertain the notion, arguing that the potential cost – a loss of hard-won inflation-fighting credentials – is too high. “We are not seeking higher inflation, we do not want higher inflation and we’re not tolerating higher inflation,” he told a February hearing in Congress.

‘Cliff’ deal is one part relief, one part frustration for Fed

When Federal Reserve Chairman Ben Bernanke was last in New York, he joked about his past research into the effect of uncertainty on investment spending. “I concluded it is not a good thing, and they gave me a PhD for that,” he said, drawing laughter from a gathering of hundreds of economists in a packed Times Square conference room.

Laughter probably wasn’t echoing through the halls of the U.S. central bank on Wednesday. Late on Tuesday, Congress struck a last-minute deal that only partially and temporarily avoids the so-called fiscal cliff. Bernanke and other Fed policymakers – frustrated that it took politicians so long to address tax and spending levels in the first place – were hoping Washington would agree to a bi-partisan, longer-term plan to narrow the country’s massive deficit with only modest near-term fiscal restraint. While no deal on taxes would have been far worse for the economy, the fact that Congress put off decisions on government spending and the debt ceiling for another two months simply prolongs the uncertainty that many feel is holding back investments by businesses and households.

“You basically continue this fiscal policy uncertainty that we have had for the past year or more,” said Roberto Perli, managing director of policy research at International Strategy and Investment Group. In a note to clients, Perli predicted that at best the fiscal cliff deal does not change the outlook for Fed policy, which for now consists of rock-bottom interest rates and $85 billion per month in asset purchases. But more likely, he wrote, it would lead to even more accommodation from the Fed since Republicans – smarting from a political defeat in the last few days – may prefer to let the “sequester” of large-scale spending cuts kick in as scheduled on March 1 rather than agreeing to a smaller reduction in U.S. debt. In that case, the Fed would respond by keeping rates lower for longer, perhaps through early 2016, or simply by ramping up the value of asset purchases under its quantitative easing program (QE3), Perli wrote.

Why the U.S. jobless rate might stop falling

The U.S. jobless rate, currently at 7.7 percent, remains elevated by historical standards. But it has fallen sharply from a peak of 10 percent in October 2009. However, that decline could soon grind to a halt, according to a recent paper from the San Francisco Federal Reserve.

Its authors argue that, because the slow but steady decline in the jobless rate has been in part due to slippage in the labor participation rate that is more a product of the business cycle than long-run demographic trends, as the Bureau of Labor Statistics presumes.

In January, the U.S. Bureau of Labor Statistics significantly reduced its projections for medium-term labor force participation. The revision implies that recent participation declines have largely been due to long-term trends rather than business-cycle effects. However, as the economy recovers, some discouraged workers may return to the labor force, boosting participation beyond the Bureau’s forecast. Given current job creation rates, if workers who want a job but are not actively looking join the labor force, the unemployment rate could stop falling in the short term.

What Bernanke didn’t tell us

Federal Reserve Chairman Ben Bernanke spoke to reporters for well over an hour at his quarterly press conference this week, but he was vague on the most important question of monetary policy today: what exactly would it take for the central bank to either ramp up or curtail the pace of monthly asset purchases? Since bond buys have effectively replaced interest rates as the dominant tool of Fed policy in recent years, the central bank’s new thresholds, which reference only rates, are not particularly useful.

After all, in the original threshold plan as crafted by its inventor, Chicago Fed President Charles Evans, the Fed would offer a jobless rate trigger for quantitative easing itself.

Asked about this during his briefing, Bernanke said:

We are prepared to vary that as new information comes in. If the economy’s outlook gets noticeably stronger we would presumably begin to ramp-down the level of purchases. But, again, the problem with giving a specific number is that there are multiple criteria on which we make this decision. We will be looking at the outlook for the labor market, which is very important. We will also be looking at other factors that could be affecting the outlook for the economy, for example – I hope it won’t happen – if the fiscal cliff occurs, as I have said many times, I don’t think the Federal Reserve has the tools to offset that event, and in that case, we obviously have to temper our expectations about what we can accomplish.

Fed’s numerical thresholds are a bad idea: Goldman’s Hatzius

Updates with Fed decision

The Federal Reserve on Wednesday took the unprecedented step of tying its low rate policy directly to unemployment, saying it will keep rates near rock bottom until the jobless rate falls to 6.5 percent. That’s as long as inflation, the other key parameter of policy, does not exceed 2.5 percent.

Jan Hatzius, chief economist at Goldman Sachs, however, said in a research note published ahead of the decision that the shift may not be very effective.

Would such a move be a good idea? We’re not so sure. Calendar guidance may be theoretically flawed, but it is working reasonably well in practice. Fed officials have managed to keep expectations for the funds rate in the next few years pinned near zero, and the market now understands that this is more of a commitment to the promotion of future economic recovery than an expectation of future economic weakness.

Fiscal tightening + monetary stimulus = ‘borderline insanity’?

It’s a curious pattern being repeated around the industrialized world. Governments are trying frantically to tighten their belts even as the monetary authorities loosen their purse strings. This week in the United States is a perfect example: the Fed looks set to extend its bond purchase program even as Washington fails to reach an agreement to avoid the dreaded “fiscal cliff.”

It’s the sort of dissonant policy that is unlikely to yield very constructive results at a time when the U.S. economy is struggling to achieve a meager 2 percent growth rate.

Thomas Lam, group chief economist at OSK-DMG inSingapore:

The current one-sided policy mix of fiscal tightening and monetary easing is problematic (for example, the UK experimented with this approach –  fiscal consolidation and monetary accommodation – and it clearly failed to generate a sustained recovery).  In some cases, it’s borderline insanity –  it’s like you’re trying the same or broadly similar approach but hoping for a different outcome every single time.

Jobs, triggers and the Fed

As Federal Reserve officials debate whether to use thresholds for inflation and joblessness to guide monetary policy, Friday’s jobs report may be a cautionary tale.  The idea of thresholds is to pick markers for potential policy change – an unemployment rate of 6.5 percent, for instance, as a guidepost for when the central bank might begin to raise rates – so that the market has a better idea of where Fed policy is headed. As the unemployment rate nears that level, the theory goes, investors will gradually start to price in tightening; if the unemployment rate rises again, they’ll price it out.

But some Fed officials, notably the hawkish heads of the Richmond, Philadelphia and Dallas regional Fed banks, oppose the idea. One reason: the unemployment rate alone cannot capture the state of the labor market. Friday’s report show why.

Unemployment in November fell to 7.7 percent, the lowest in nearly four years. But the decline was not a sign of labor market strength – far from it. People were giving up looking for jobs, signaling hopelessness, not hope.

Would you recognize Fed ‘easing’ if you saw it?

By almost all accounts, the Federal Reserve is expected to “stay the course” on its massive bond-buying program after next week’s policy-setting meeting. That would mean a continuation of the $85 billion/month in total purchases of longer-term securities, probably consisting of $40 billion in mortgage bonds and another $45 billion in Treasuries. Laurence Meyer of Macroeconomic Advisers is one of countless forecasters predicting this, calling it the “status quo.”

Problem is, the U.S. central bank’s current policy is not simply to buy $85 billion in bonds — and if it does announce such a program on Wednesday, it should probably be interpreted as policy easing, not a continuation of current policy.

The $45 billion in longer-term Treasuries is part of a program called Operation Twist that offsets those purchases with $45 billion in sales of shorter term Treasuries. In June, Fed policymakers extended Twist to the end of the year, meaning the market — which rallies each time the Fed eases policy — should have priced in an end to the $45 billion shuffle in the Fed’s portfolio of assets. It also means that there is really only $40 billion in outright bond-buying happening today, as part of the Fed’s third round of quantitative easing (QE3). Not $85 billion.

Bernanke’s structuralist concession: Fed chief quietly downgrades U.S. economic potential

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For the first time, Federal Reserve Chairman Ben Bernanke has given credence to the idea that America’s long-term economic potential may have been permanently scarred by the turmoil of recent years. In a speech to the Economic Club of New York, Bernanke said:

 The accumulating evidence does appear consistent with the financial crisis and the associated recession having reduced the potential growth rate of our economy somewhat during the past few years. In particular, slower growth of potential output would help explain why the unemployment rate has declined in the face of the relatively modest output gains we have seen during the recovery.

True, Bernanke came nowhere near saying monetary policy was impotent to improve the situation. Indeed, he argued that the weaker potential growth “seems at best a partial explanation of the disappointing pace of the economic recovery.”