The Fed’s toolkit: down but not quite out
U.S. Federal Reserve officials mulled a fresh round of bond purchases among other policy tools to ease financial conditions, according to minutes of their September meeting.
Fed officials discussed measures to ease monetary policy ranging from lengthening the average maturity in the Fed’s portfolio to lower long-term interest rates — the step they ultimately took last month — to providing explicit guidance about their goals for the labor market.
In a move known as Operation Twist, the Fed committed to selling $400 billion in short-dated Treasuries and use the money to purchase longer-term bonds. Following are some of the additional measures officials are debating:
BOLSTER POLICY ASSURANCE, SET TARGETS
Communications steps are the lowest hanging fruit for Fed policy, since it requires only verbal assurances rather than commitment of new funds.
The Fed in August took the unprecedented step of offering a specific time frame for which it would likely to keep policy ultra-loose, saying it expected economic conditions would warrant an exceptionally low federal funds rate at least through the middle of 2013.
While three officials dissented against the move, others wanted to take bolder steps immediately. The central bank actively discussed something akin to a price-level targeting system where policymakers would explicitly link the path of interest rates to the direction of unemployment and inflation.
Inflation is so last quarter
Sure, many U.S. inflation indicators have been moving higher in recent months. But that’s because most of them are really a look into the rearview mirror, argue economists at JP Morgan. In a note entitled “The rise in U.S. inflation is yesterday’s headache,” they say the same pattern was observed in early 2008, just before a deepening financial crisis dragged prices lower across the world economy:
At first glance the rise in inflation looks anomalous against the backdrop of persistently disappointing U.S. and global growth and hints at an intractable stagflation problem. But it is very likely that the rise in both inflation and core inflation will prove temporary and soon recede. In this regard,the inflation performance in early 2008 provides a useful model. Then, as now, inflation rose while the economy was weakening. And then, as now, the rise in inflation mainly reflected the upward pressure on goods prices from much higher commodity prices and a weakening dollar.
That means the Fed, which has just announced a fresh effort to push down long-term borrowing costs, may have room to ease monetary policy further if it feels the need.
Plus, a little inflation could go a long way to getting some homeowners back in the black and keep investors from sitting on cash.
Doing the Twist, and other Fed tools
For markets, it’s a fait accompli: the Federal Reserve, which meets on Tuesday and Wednesday, is expected to push for some variation on a 1961 policy, known as Operation Twist because it aims to push down long-term borrowing costs while nudging short-term rates higher. Primary dealer banks polled by Reuters two weeks ago, just after the Labor Department reported the U.S. job market had stagnated in August, saw an 80 percent chance that some of sort of twist-like measure would be put into place.
Still, there are a number of variants the Fed could employ:
Half Twist: The most modest, perhaps too weak given market fragility, would be to direct proceeds from existing bonds on the balance sheet into longer-dated Treasury securities.
Full Twist: A more aggressive approach would involve active sales of short-dated bills and longer bond buys, and attempt to flatten the yield curve to effectively force investors to take more risk by lending at longer maturities. A February paper from the San Francisco Fed argued that, unlike the conventional wisdom that the original Operation Twist was a failure, the measure actually drove down long term Treasury yields by what the study calls a “highly statistically significant” 0.15 percentage point.
QE3-Lite: In order to overcome the objections of the Fed’s inflation hawks to a further expansion of the $2.9 trillion balance sheet, officials could choose to “sterilize” any new bond purchases by conducting open market operations such as reverse repos to drain reserves even as it injects temporary liquidity. This option might be thought of as QE3-lite.
QE3: A fresh bond purchase program, a full QE3, is not seen as on the table for now, but remains an option if growth fails to pick up. The second round of bond buying implemented late last year prompted heavy criticism from conservative economists and emerging market policymakers.
Evans doctrine gains traction at Fed
Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.
One particularly striking passage in minutes to the Fed’s August meeting signaled such an approach was much closer to becoming policy than investors and economists had believed:
In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting.
Reuters flagged the theme on Sept. 2 (Fed could get specific on goals if recession hits), just as Chicago Fed President Charles Evans began campaigning for such an approach, which depending on its form might be referred to as price-level targeting. Under such a regime, the Fed would allow inflation to surpass its 2 percent goal for a period, letting it rise to, say, 3 percent, in an effort to stimulate investment and economic activity. Evans argued before the European Economics and Financial Centre in London last week:
We need to take strong action now. Given how truly badly we are doing in meeting our employment mandate, I argue that the Fed should seriously consider actions that would add very significant amounts of policy accommodation. If 5 percent inflation would have our hair on fire, so should 9 percent unemployment. Such further policy accommodation does increase the risk that inflation could rise temporarily above our long-term goal of 2%. I do not think that a temporary period of inflation above 2% is something to regard with horror.
Is Evans alone? JP Morgan’s resident Fed watcher Michael Feroli thinks not:
Well, inflation is no big deal if you are as financially comfortable as these guys! It becomes a big deal for those millions of families out there that are just barely getting by now and for whom even a slight increase in the price of gas, groceries, clothes, and other necessities may well tip them over the edge.
The big easy: Bernanke readies September move
Fed Chairman Ben Bernanke’s speech to the Economic Club of Minnesota was long on theory and short on details. Still, Bernanke made one thing clear: the central bank is revving up to ease monetary policy further. Most analysts are looking for some sort of effort to push down long-term rates at the September meeting. While Bernanke did not offer any further guidance on method, he did present a very distinctive sense of direction.
A renewed focus on growth ratcheted the Fed chief’s tone up a notch from his remarks at Jackson Hole:
The Federal Reserve will certainly do all that it can to help restore high rates of growth and employment in a context of price stability.
Bernanke also appeared keen to assuage the concerns of more hawkish Fed members.
We see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy.
And later in the speech:
In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.
Jackson Hole snapshot: QE3, the chances of recession, and pints of blood
In Jackson Hole, where central bankers and leading economists from around the world are gathering for an annual meeting hosted by the Kansas City Fed, the talk is about the economy, what Fed Chairman Ben Bernanke will signal in his highly anticipated speech on Friday and what Warren Buffett’s purchase of a stake in Bank of America might mean for the beleaguered bank.
Here’s a smattering from interviews on the sidelines of the meeting, which begins in earnest with a formal dinner tonight:
– “QE3 is not in the cards, so don’t expect that,” Bank of America economist Mickey Levy told Reuters Insider, referring to the possibility of a third round of bond-buying by the Fed. Instead, the Fed may aim to reduce long-term rates by replacing some of the shorter-term securities in its portfolio with longer-term assets, he said.
– John Silvia, an economist at Wells Fargo Securities, said such a step would be a “small move,” and suggested that with three dissenting votes on the Fed’s policy-setting panel Bernanke would be more likely to go slow than fast. “Three dissents do matter,” he said.
– Carnegie Mellon professor and Fed historian Alan Meltzer, who has attended nearly every annual Jackson Hole meeting since its inception 29 years ago, suggested there’s about as little Bernanke can do about the economy as about the torrential downpour that drenched the mountain valley minutes before his interview.
“Look, I’ve done what I can,” he advised Bernanke to tell his audience. “There are other things that can be done, but they’re not things that I have to do.” Meltzer said the United States does not look to be headed back toward recession, but growth will be slow.
July inflation spike won’t stop QE3
Let’s face it: inflation is a lagging indicator and Federal Reserve officials look at it that way. So for all the talk that the Fed now faces a higher bar for a third round of quantitative easing, the rise in core consumer prices to 1.8 percent in July is likely to be seen as temporary. As analysts from Commerzbank put it, “the weak economy should help to contain inflationary pressure.”
More worrying for policymakers, particularly the more dovish members of the Federal Open Market Committee, are hints the third quarter may not be showing a lot of the improvements built into official forecasts. A string of reports ranging from consumer sentiment to manufacturing suggest things may have actually taken a turn for the worse in August. From a Goldman Sachs note:
The Philadelphia Fed index unexpectedly fell to -30.7 in August. In the past, this level for the index has only been observed in or immediately prior to recessions (though the index was around -20 in 1995 for a brief period, and the economy did not fall into recession).
Some analysts point to the three dissents against the Fed’s decision this month to promise to keep rates near zero for another two years as making it harder for Fed Chairman Ben Bernanke to push for additional stimulus despite signs of economic weakness. Steven Ricchiuto, chief economist at Mizuho:
Recent comments by members of the FOMC who dissented from last week’s policy decision to maintain excessively low short-term rates through mid-2013 suggests that there is a bigger rift between the inflation hawks and the pro-growth faction on the policy making board. In fact, yesterday’s comments by Philadelphia Fed President Charles Plosser suggest that there is little room for the Fed chairman to push for any further accommodative steps when he addresses the Kansas City Fed conference in Jackson Hole next week.
That view may be a bit strong. The core of the committee is dovish, activist and it appears very concerned about a prolonged period of sluggish growth. Some would probably like to act sooner rather than later and the Jackson Hole speech at the end of this month would be the perfect setting in which to do it. Indeed, Commerzbank sees the chances of recession as having rapidly increased, and with them the likelihood of further Fed easing:
The Philadelphia Fed’s index of regional manufacturing business conditions slumped more than 30 points to -30.7 in August. Such index levels have never been seen outside recessions. The odds are rising that the nationwide ISM index will also drop into contraction territory. Thus, the US economy might be on the brink of a new recession. The odds are rising that Fed chairman Bernanke will announce additional measures in his speech in Jackson Hole on Friday next week.
inflation is just a way to accommodate the leverage junkies so they can do it all over again.
oil producers will raise prices, immediately…….to maintain the value, the purchasing power of the dollars they receive.
Who is inflation supposed to help…..?…
..it’s not going to create jobs, that have any purchasing power. Wage stagnation will result, and consumer costs will go up. Good luck, if you are on a fixed income
The core issue is purchasing power……..
Kocherlakota explains Fed dissent
Minneapolis Federal Reserve President Narayana Kocherlakota on Friday released the following statement explaining his vote against the U.S. central bank’s decision this week to declare that interest rates will likely remain near zero until mid-2013:
One of my jobs as president of the Federal Reserve Bank of Minneapolis is to serve on the Federal Open Market Committee. At its last meeting on August 9, the Committee took what I viewed as a significant policy step. I dissented from its decision. I believe that transparency is an essential part of effective policy formation, and so I’m offering this brief explanation of my decision. These views are not necessarily those of others on the Federal Open Market Committee, including presidents Richard Fisher and Charles Plosser.
Entering the meeting, the FOMC was following an unprecedentedly accommodative monetary policy. There were three elements to this policy. First, the Federal Reserve owned over $2.5 trillion of long-term government and government-backed securities. The purchase of the final $600 billion of these assets was announced in November 2010 and completed by the end of June 2011. Second, as it had since December 2008, the Committee was maintaining the fed funds rate at between 0 and 25 basis points. Third, as it had since March 2009, the Committee statement included the forward guidance that it anticipated keeping the fed funds rate at this low level for “an extended period.” The “extended period” is generally interpreted as being between three and six months.
The Committee adopted this three-part policy stance in November 2010. I agreed with this decision and supported it publicly at that time and throughout this year.
In its August 9 meeting, the Committee changed this “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013.” This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before.
I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November.
I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.
Going forward, my votes on monetary policy will continue to be based on the evolution of the data on PCE inflation and its components, medium-term PCE inflation expectations, and unemployment.
Kocherlakota apparently doesn’t understand the difference between the Fed owning bonds and the Fed buying bonds.
Communications breakdown at the Fed?
Last month the U.S. Federal Reserve published a new communications policy designed to keep the dissonant voices of central bank officials in check and prevent leaks of market-sensitive information. Among the rules, is a blackout period from the Tuesday before any policy-setting meeting to midnight of the Thursday after during which participants must “refrain from expressing their views about macroeconomic developments or monetary policy issues in meetings or conversations with members of the public.”
So it was curious that on Wednesday, just a day after three members of the Fed’s policy-setting committee revolted against Chairman Ben Bernanke’s pledge to keep interest rates low for the next two years, one of the dissenters – Minneapolis Fed President Narayana Kocherlakota – suggested to the Wall Street Journal that his revolt may be only temporary.
On this occasion, I dissented from the Committee’s decision. Regardless, I have nothing but the highest regard for the acumen, integrity, and ability of all other FOMC meeting participants.
The WSJ asked for comment on the Chairman’s leadership. Philadelphia Fed President Charles Plosser declined to comment. Dallas Fed President Richard Fisher, who helped write the Fed’s new communications policy, stuck to the question in his response, saying “I think very highly of Ben, admire him, appreciate his style, find him totally honest and inclusive, and also respectful of others’ principles and views.”
Only Kocherlakota mentioned the dissent specifically, even though, his spokeswoman said, he wasn’t asked. She declined to comment on whether the comment violated the blackout period. The Federal Reserve Board, which set the new rules, also declined to comment on whether they had been violated.
Kocherlakota expanded by praising Bernanke further.
Ben Bernanke is an outstanding chairman for the Federal Reserve Board of Governors. He actively cultivates the expression of disparate views, and that dialogue leads to better monetary policy choices for the United States.
About those low rates … we really really mean it
The Fed this week took the unprecedented step of putting interest rates of virtual permahold for a set period of time — in this case, until the middle of 2013. That’s a long time away, and the promise underscores just how concerned about the central bank is about the U.S. economic outlook. In the short-run, it looked a clever trick, stemming a precipitous slide in global stock markets. (The hint that it might be prepared to take even further action didn’t hurt either). But will the Fed’s doubling-down on its “extended period” pledge work to support a flagging economic recovery when other, stronger unconventional monetary tools have already been deployed to questionable avail?
Many economists think the move is unlikely to have a major impact on growth or the nation’s jobless rate, which has been hovering around 9 percent since the start of the year. A lack of employment prospects, weak consumer demand and a major housing overhang — not high borrowing costs — are the main impediment to economic progress at the moment, they say. And for that particular ailment, monetary policy has proven an especially blunt tool.
Yet with Washington focused on cutting spending, fiscal policy appears largely off the table. Fed Chairman Ben Bernanke has warned Congress that despite the need for longer-term steps to reduce the U.S. budget deficit, the government should be careful not to cut spending too quickly. Given just how weak U.S. GDP growth has proved this year — economists in a Reuters poll now see 2011 growth at a paltry 1.7 percent — Bernanke may be wishing he had been a little more vocal in urging for a proactive fiscal policy to get the country of the doldrums.
Back in 2003, when he was a governor at the Fed’s board, Bernanke gave a speech in Tokyo in which he recommended that Japan should consider “explicit (though temporary) cooperation between the monetary and the fiscal authorities.” True, Japan was facing a prolonged deflation, which the U.S. has thus far escaped — in large part, Fed officials argue, because of their aggressive efforts on the monetary front. Yet given the eerie similarities between America’s economic stagnation and Japan’s own malaise, Bernanke’s policy prescriptions are strikingly radical. The full speech is certainly worth reading, but here is the jist of it:
My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt–so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent.
Under this plan, the BOJ’s balance sheet is protected by the bond conversion program, and the government’s concerns about its outstanding stock of debt are mitigated because increases in its debt are purchased by the BOJ rather than sold to the private sector. Moreover, consumers and businesses should be willing to spend rather than save the bulk of their tax cut: They have extra cash on hand, but–because the BOJ purchased government debt in the amount of the tax cut–no current or future debt service burden has been created to imply increased future taxes.
