Fed Policy: The Path to QE2

Earlier this year the Fed was all about mapping the way out of their unusually accommodative monetary policy; the “exit strategy” was all the rage. But then the economy became “unusually uncertain”. That’s how Bernanke phrased it in his semi-annual congressional testimony in July and almost from that point forward the Fed began to circle back. Instead of taking a nearby exit to normalization the Fed is now intent on moving further down the road of accommodation. The policy pivot was as swift as it was utterly complete and we shall not be hearing about a strategy to exit for a long time to come. Here is a brief timeline of the path to QE2.

August 10: Fed votes to avoid “perverse outcome”.

The post meeting statement from the August FOMC meeting notified the market that the Fed would be “reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.” To have done otherwise would have allowed “an undesirable passive tightening of policy”; that’s how Bernanke put it in his August 27 Jackson Hole speech. In that speech he explained that, “At their most recent meeting, FOMC participants observed that allowing the Federal Reserve’s balance sheet to shrink in this way at a time when the outlook had weakened somewhat was inconsistent with the Committee’s intention to provide the monetary accommodation necessary to support the recovery. Moreover, a bad dynamic could come into at play: Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed’s balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening—a perverse outcome.”

September 21: The Confession.

By an act of Congress the Fed has a dual mandate; they are required to promote effectively the goals of maximum employment and stable prices. In their September FOMC statement they admitted that they are failing on both counts; “Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.” Without saying so directly, this passage indicated that the Fed was acknowledging that the status quo was no longer acceptable.

October 1: A Stalking Horse Speaks.

New York Fed President William Dudley spoke on the first day of the month, making clear that the economy is not in a spot of the Fed’s liking, does not seem capable of achieving that measure of success in a timely fashion and therefore further policy action is likely to be warranted; his comments echoed, and elaborated on, the sentiments expressed by Bernanke in Jackson Hole. “Currently, my assessment is that both the current levels of unemployment and inflation and the timeframe over which they are likely to return to levels consistent with our mandate are unacceptable,” said the NY Fed boss. “In addition, the longer this situation prevails and the US economy is stuck with the current level of slack and disinflationary pressure, the greater the likelihood that a further shock could push us still further from our dual mandate objectives and closer to outright deflation.”
“So what could the Federal Reserve do?” asked Dudley in his speech. Of course he brought up the idea of expanding the Fed’s balance sheet by purchasing “medium and long-term Treasuries or agency mortgage-backed securities.” He figures that “such purchases of long-duration assets pull down the level of long-term interest rates by removing duration from private-sector hands, who respond by purchasing other long-dated assets.” Dudley used in his example a figure of $500 billion worth of buying. I doubt he would have taken the occasion to over shoot on a number and therefore disappoint the market, so I think this number should be considered a floor from which the Fed would build. I think a pre-announced ceiling is unlikely, but I do think any initial figure will be potentially nothing more than a starting point; the buy ticket will be open ended, capped only by favorable economic developments.

But an even more interesting aspect to Dudley’s speech was the tactic he mentioned as the first of “two potentially complementary avenues.” He said, “First, we could take steps to make our current highly accommodative stance of monetary policy more effective in stimulating economic activity by providing additional guidance about what we are trying to achieve today and in the future…By clarifying our intentions, we can reduce the risk of further disinflation—or even an outright debt-deflation spiral that would make it still more difficult to accomplish the necessary balances sheet adjustments.” This pre-commitment strategy, in essence guaranteeing that the ultra easy policy would remain in place until some clearly stated inflation objective was achieved, is a favorite of Bernanke’s, at least since he read about it in the “Zero Bound” paper written by Eggertsson and Woodford in 2003. This is why I suggest Dudley acted as the Chairman’s stalking horse by so prominently and extensively discussing this particular commitment strategy.

October 15: Bernanke Removes Any Doubt.

During his mid-month speech at a Boston Fed conference on monetary policy in a low-inflation environment Chairman Bernanke made clear his intention to pursue additional quantitative easing; “Given the Committee’s objectives, there would appear—all else being equal—to be a case for further action.” Of course he addressed the idea of buying longer-term securities, trumpeting his view that “empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.” But this strategy and his opinion of it was well anticipated by the market.
I think the key aspect of the speech concerned central bank communication. “A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect,” suggested Bernanke. “Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.” He has been on the record for a number of years that this type of communication, which would include a pre-commitment to keep rates low until an economic target, especially inflation, has been achieved, is an excellent compliment to buying longer-term securities. However, the Financial Times reported recently that this style of communication is a controversial strategy for some members of the Fed’s policy Committee and Bernanke did indeed tread a little softly on the chances of such a move; “A potential drawback of using the FOMC’s statement in this way is that, at least without a comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality.”

But Bernanke may have laid the groundwork for both clearing up any confusion in regards to the Fed’s objective in a pre-commitment strategy and for doing the necessary sales job on his more reluctant colleagues on such a policy. In the Boston speech the Chairman did not set an official inflation target, but he did explain that because of the Fed member’s longer-run inflation projections it was fair to say that “FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below.” That said, it could be that he will attempt to push the FOMC to agree and then communicate to the public, that the unusually easy monetary policy will stay in place until the inflation rate is at, near, or fast approaching this unofficial target. I don’t think this aspect of QE2 has been fully priced into the market and the possibility of such a strategy, while hardly a done deal, cannot be ignored. And, it should be noted, that as of their most recent economic projections, the FOMC does not see inflation rising to the “mandate consistent” level by the end of 2012, at least; even when they assume that monetary policy will be nothing but appropriate in the interim and that the economy suffers no shock during that time.

(While stable prices may be the first amongst equals in the Fed’s dual mandate, it doesn’t mean it is at the expense of employment, at least that was a point that Dudley tried to make in his October 1 speech, “If we were to go down this path, it would be important to note that any provision of more information on our inflation objective would not be a signal that the inflation element of the dual mandate had become more important than the full employment objective. Instead, it would principally reflect the fact that inflation being ‘too low’ (just like inflation being ‘too high’) is an impediment to achieving the full employment objective of the dual mandate.”)
November 3: The Fed Announces “QE, The Sequel”

At about 1:15pm on Wednesday November 3 the Fed released a statement indicating…

Some Date in the Future: Controversial Fed Policy was…

Reprinted shamelessly from the desk of Lou Brien