MacroScope

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.

In the working paper co-authored with San Francisco Fed economist Eric Swanson and quietly posted to the San Francisco Fed’s website on Monday, Williams argued that five-year and 10-year Treasuries traders still respond with as much vigor to economic news as they did before the financial crisis. As Williams explained to reporters after a speech Monday at Claremont McKenna College:

We continue to see the markets reacting to information — they still give a signal for what they are thinking about when the Fed’s going to do (what), what policy is going to be, what they think of the future path of the economy. The markets are still working, they are still digesting the information, and they are still responding to it.

Ask not what your monetary policy can do for you, but what you can do for your monetary policy. That’s the jist of a 1968 paper by Milton Friedman, the poster-child for monetarist economics, entitled “The Role of Monetary Policy,” whose key questions remain hotly debated more than four decades on. Friedman’s answer is simple (some might argue too simple), and all too familiar to those who read the speeches of present-day Federal Reserve hawks – focus on the only thing monetary policy can truly control, which in Frideman’s view is price stability.

By setting itself a steady course and keeping to it, the monetary authority could make a major contribution to promoting economic stability. By making that course one of steady but moderate growth in the quantity of money, it would make a major contribution to avoidance of either inflation or deflation of prices. […] That is the most that we can ask from monetary policy at our present stage of knowledge.

Friedman’s writing suggests he was not a big fan of the Fed’s own dual-mandate, introduced in 1978. Any effort to goose employment through a persistent period of low very low interest rates, Friedman argues, would likely lead to overshooting and inflation.

Should central bankers be more like Miles Davis — experimental, improvisational, and out in front — or a Dixieland band — traditional, predictable, and in the background?

That question was the theme of a discussion at the Council on Foreign Relations in New York yesterday morning that featured Arminio Fraga, a former governor of the Central Bank of Brazil; Kevin Warsh, a former governor of the Federal Reserve Board; and Adam Posen, an American economist who currently sits on Bank of England’s Monetary Policy Committee (and who coined the Davis/Dixieland dichotomy). Within the panel, which was entitled “Central Banking in an Age of Improvisation,” there was discord about how activist monetary policy should be when interest rates are already at the zero bound and when the economy was not undergoing a financial crisis.

For Posen, the big fear is that in fifty years the current period will be remembered as a “major deflationary mistake.” In a series of op-eds and speeches this year, Posen has consistently called for more stimulative monetary policy, urging central banks to undertake unconventional maneuvers like purchasing long-term government bonds or even backing new public institutions that would lend directly to small- and medium-sized enterprises or securitize illiquid SME loans. He is not wide-eyed enough to believe that further easing will be a panacea, but does maintain that “irresponsible monetary tightening will make your problems insoluble.”

By Amer Bisat
All opinions expressed are his own.

In recent weeks, financial markets have behaved as if the global economy is a plane crashing with no parachute in sight.  The price action is not entirely irrational.  Global growth has indeed fallen sharply and suddenly.  At the same time, the ability of policy makers to engage in bold counter-cyclical measures is being severely constrained by budgetary and political realities.

That said, the assumption that economic policy in the developed world is utterly impotent is an exaggeration.  Monetary policy in the U.S. is a good case in point. The Fed’s tool box is far from empty.  Given the persistent economic weakness and the severe headwinds facing the U.S. over the next few years, it is time for the Fed to become (even) more aggressive.

The notion that the Fed “can do nothing” is fast becoming conventional wisdom.  To an extent, it is naïve to completely dismiss the view.  Monetary policy effectiveness and the Fed’s political room-for-maneuver are arguably both at a historic low. For one thing, even though the Fed has already lowered interest rates to zero (and tripled its balance sheet), U.S. growth is frustratingly tepid.  Politically, the attacks on the Fed no longer emanate from the fringe but now represent the view of important segments of the political and academic mainstream.  The pressure, in fact, has contaminated intra-FOMC dynamics with a rarely seen concentration of dissenting voices within the Committee complicating the Fed’s traditionally consensus-based decision making process.

The U.S. Federal Reserve’s hotly-contested $600 billion renewal of its quantitative easing programme is roughly the size of the Gross Domestic Product of Switzerland.

Expectations by forecasters in Reuters Polls on how much more bond purchases the Fed will conduct beyond the $1.7 trillion already conducted varied widely running up to the Fed’s announcement that it would go ahead with QE2.

But the high end of forecasts has been consistently driven by the 18 primary bond dealers which deal directly with the Fed. Perhaps that’s no surprise, given that they are selling bonds to the central bank at a very good price.

Interesting twist at the moment - how are financial markets going to view not-so-bad or good data out of the United States in the run-up to the next Federal Reserve meeting.

Investors have been pricing in a chunky operation by the Fed to feed the markets with cheap cash – look at the gold, silver, the Australian dollar and the Canadian dollar. Bad data from the United States will keep investors confident of such Fed action and support the flows into high yielding assets.

But any data showing the pace of recovery in the world’s largest economy is not in such a bad shape. Investors will adjust their expectations and positions, causing a sell-off in equities, speculative-grade credit and high-yielding currencies.

Fed officials eager to give the ailing job market some relief are showing their stripes – or perhaps their feathers – and adding to their ranks, making it seem more likely the U.S. central bank will provide further monetary easing.

The Fed has a dual mandate to provide price stability and ensure full employment. Policy makers who place priority on supporting economic growth and keeping unemployment low are called doves while those who would endure uncomfortable unemployment in order to keep inflation at bay are called hawks.

The doves were not only louder but became more numerous this week. First, the Senate voted to confirm Janet Yellen as Fed vice chairman and Sarah Raskin as a member of the board of governors.

Even the Federal Reserve official who is one of those most opposed to further financial easing by the U.S. central bank has thoughts about how the Fed ought to do it.

Philadelphia Federal Reserve Bank President Charles Plosser on Wednesday told reporters in Vineland N.J.  that while he doesn’t think the economy is now in need of further Fed asset purchases, he would support such a move if a clear risk of deflation emerges.

The conditions Plosser set out for any eventual asset buying give a flavor of the debate at the Fed as it considers how to proceed with a renewal of quantitative easing, as the process of pushing additional reserves into the financial system by purchasing securities is called.

When the Bank of England decided to expand its quantitative easing policy by 25 billion pounds to 200 billion on Thursday, it was essentially hedging its bets.

After Britain's economy shrank unexpectedly in the third quarter, and with two thirds of the City expecting an expansion to the QE programme, simply shutting off the tap of government bond purchases would risk being more of a shock than the economy could bear.

On the other hand, the Bank clearly believes that the worst is over for the economy and that recovery will come soon -- even if it's going to be weak.

Five things to think about this week:

APPETITE TO CHASE? 
- Equity bulls have managed to retain the upper hand so far and the MSCI world index is up almost 50 percent from its March lows. However, earnings may need to show signs of rebounding for the rally's momentum to be sustained. Even those looking for further equity gains think the rise in stock prices will lag that in earnings once the earnings recovery gets underway, as was the case in past cycles. The symmetry/asymmetry of market reaction to data this week -- as much from China as from the major developed economies -- will show how much appetite there is to keep chasing the rally higher. 

TAKING CONSUMERS' PULSE 
- A better picture of the health of the consumer will emerge this week as U.S. retailers' earnings coincides with the release of U.S. July retail sales data and the UK BRC retail survey comes out on the other side of the Atlantic. With joblessness still rising, the reports will show how willing households are to spend and whether deep discounts, which eat into retailers' profit margins, are the only thing that will tempt them to shop -- both key issues for the macroeconomic and corporate outlook. 

CENTRAL BANK WATCH 
- After last week's Bank of England surprise, all eyes turn to what sort of signals the U.S. Federal Reserve and Bank of Japan will send on the outlook for their respective economies and QE programmes. After the BOE's expansion of its QE programme the short sterling strip repriced how soon UK rates would rise. But the broader trend recently in the U.S., euro zone and the UK has been to discount rate rises in 2010 -- and possibly as soon as this year in Australia. Benchmark interbank euro rates have risen for the first time in two months, and central bankers everywhere, including China, face the delicate balancing act of managing monetary tightening expectations in the months ahead.