MacroScope

Suddenly, it’s the two lone doves who find themselves on the outside of the Federal Reserve’s policy consensus. Until recently, it was the hawks who were in the minority. But minutes of the central bank’s March meeting suggest policymakers are becoming less keen to launch a fresh round of monetary stimulus as the U.S. economy improves.

They key difference came from the minutes’ characterization of officials’ inclinations toward a third round of quantitative easing or QE3.

Here is what the January minutes had said:

A few members observed that, in their judgment, current and prospective economic conditions – including elevated unemployment and inflation at or below the Committee’s objective – could warrant the initiation of additional securities purchases before long. Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Contrast that with March’s thinning ranks of QE3 proponents.

A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Sometimes, markets just don’t make a lot of sense. Take Fed Chairman Ben Bernanke’s two-day testimony this week. Bernanke was his usual dovish self on Wednesday, emphasizing risks to U.S. growth and the likelihood of slow progress on bringing down the jobless rate. Yet global markets suddenly panicked, apparently because the Fed chief did not directly give any hints of imminent easing. It’s surprising that markets would be surprised by this, however, given that few expected any such signals.

On Thursday, however, stocks recovered their footing. By then, it was time for the bond market to use the old Bernanke excuse for a decent selloff of its own.

Yet the basic message in both days of testimony was that economic conditions are still not to the central bank’s liking and that further action does remain on the table. Bernanke’s lack of faith in the recovery is striking:

Things are  looking a bit unsteady in the euro zone’s economy.  Just ask Olli Rehn, the EU’s top economic official, who warned this week of  “risky imbalances” in 12 of the European Union’s 27 members. And that’s doesn’t include Greece, which is too wobbly for words. 

Rehn is looking longer term, trying to prevent the next crisis. But the here-and-now is just as wobbly. The euro zone’s economy, which generates 16 percent of world output, shrunk at the end of 2011 and most economists expect the 17-nation currency area to wallow in recession this year and contract around 0.4 percent overall. Few would have been able to see it coming at the start of last year, when Europe’s factories were driving a recovery from the 2008-2009 Great Recession. And it shows just how poisonous the sovereign debt saga has become.

Not everyone thinks things are so shaky.  Unicredit’s chief euro zone economist, Marco Valli, is among the few who believe the euro zone will skirt a recession — defined by two consecutive quarters of contraction — in 2012. This year is “bound to witness a gradual but steady improvement in underlying growth momentum,” Valli said, saying the fourth quarter was the low point in the euro zone business cycle.

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.

Anyone worried that the U.S. Federal Reserve tied its policy hands with its announcement last month that  it is likely to keep short-term interest rates exceptionally low through late 2014 should take heart in the market reaction to Friday’s jobs report, which blew expectations out of the water.

Bond and interest-rate futures plunged after the report, which showed employers added 243,000 jobs in December, far more than the 150,000 economists had expected. Unemployment dropped to 8.3 percent in another encouraging sign. Fed fund futures contracts began pricing in a good chance of a rate hike by the second quarter of 2014. Before the report, bets were on a first rate hike at some point in the third quarter.

Some officials and analysts have publicly worried about the chilling effects of a Fed that signaled low rates for so long, a move they say threatens confidence just as the economy is showing signs of improvement and leaves the impression that the late-2014 date is a commitment.

Federal Reserve Chairman Ben Bernanke has made clear the central bank is considering another round of monetary stimulus. Fed officials have also suggested that if they were to embark on a third round of quantitative easing via bond purchases, or QE3, they could favor mortgage-backed securities in an effort to boost housing.

Not to read too much into anecdotal evidence, but it’s hard not to see some symbolism in Bernanke’s next public appearance, announced late on Thursday. On February 10, Bernanke will be in Orange County, California, one of the epicenters of the U.S. housing crisis. His chosen forum? The National Association of Homebuilders International Builders’ Show. The topic: Housing Markets in Transition.

The Fed is being more transparent. Any questions? Lots, apparently. Wall Street economists have published a flurry of research notes speculating about just how much new information the U.S. central bank will release along with its federal funds forecasts on Wednesday, and what form it will be presented in.

Even Vincent Reinhart, a former Fed economist now at Morgan Stanley, doesn’t know what to make of it:

Many market participants admit to being somewhat confused about the new disclosure policy. The exercise should be viewed as incremental in nature, limited by design flaws, and as likely to cloud as to clarify the public’s understanding of policy intent, at least at the outset. And the mission statement, if one appears, may amount to little more than a strong commitment to motherhood and apple pie among central bankers – i.e., the importance of price stability in the long run – but provide no practical guidance as to near-term policy choices.

The Federal Reserve could announce an official inflation target as early as its January 24-25 meeting, part of an ongoing effort to boost transparency.

Most analysts expect the central bank will stick with the target previously pronounced by Fed Chairman Ben Bernanke of 2 percent or a bit lower.

What exactly is an inflation target and what are its purposes? What are the downsides of publicly stating an inflation goal? Here are some questions and answers.

Forecasting hard data can be difficult enough. Estimating the forecasts of individual Federal Reserve policymakers is even tougher. But, in advance of the Fed’s latest effort at policy transparency, that’s just what Goldman Sachs economists have attempted to do.

The Fed announced last week it would begin publishing policymakers’ own forecasts for the path of interest rates, in addition to the growth, inflation and employment projections they already release on a quarterly basis. Goldman uses the Taylor rule of monetary policy, which governs the relationship between economic slack and inflation, to estimate when individual policymakers would likely perceive the timing of an eventual interest rate hike.

The findings are interesting, particularly because they find that, contrary to the view chronicled in this post, the publication of Fed officials’ forecasts might actually have the effect of tightening financial market conditions.

The Fed’s decision to begin publishing policymakers’ own forecasts for the path of policy may effectively constitute a minor easing of the central bank’s already ultra-loose monetary policy at its Jan. 24-25 meeting, according to Harm Bandholz of UniCredit. That’s because in doing so, officials will likely show that they expect the benchmark federal funds rate to remain near rock bottom levels until later than mid-2013 – the Fed’s current guidance on policy.

While the minutes do not say in which direction the forward guidance should be adjusted, we assume that mid-2013 is seen by many FOMC officials as too early. In that context, the decision for Fed officials to publish their projections of the target fed funds rate could provide an opportunity for a back door policy easing in January. If e.g. most participants would not pencil in any rate hike until the end of 2014, the market would certainly take this as a strong signal.

Along the same lines, David Hensley at JP Morgan says:

All else constant, these projections would further flatten the yield curve if the FOMC signals a later start to rate hikes than currently is discounted in markets.