The Fed swaps one course of monetary drugs for another
Stephen King
December 19, 2013
Job done, at least for now. Ben Bernanke and his colleagues at the Federal Reserve will be delighted at the market reaction following their monetary “pincer movement” on Wednesday. The Fed will taper its asset purchases by $10bn a month in January – down from $85bn to $75bn a month – with a strong hint that further tapering will occur as 2014 progresses.
At the same time, however, the Fed has strengthened its “forward guidance” message. Simply put, America’s central bank is promising low interest rates for longer. If the Fed’s forecasts are to be believed, rates will now be 25 basis points lower than previously projected at the end of both 2015 and 2016. Mr Bernanke has even managed to ease some of the tensions that had muddied the Federal Open Market Committee’s message over recent months. Those members who had previously offered a more hawkish view on interest rates appear to have had their talons trimmed.
We have, thus, shifted from one course of monetary drugs to another. The side effects from quantitative easing were becoming troublesome: the Fed’s rapidly-expanding balance sheet was raising eyebrows in Congress; financial assets were becoming ever-more expensive even as the pace of economic recovery remained lacklustre; and hot money flows globally were reigniting imbalances in parts of the emerging world.
The Fed recognised much of this earlier in the year but, at that stage, hadn’t quite worked out a strategy to avoid the onset of post-QE cold turkey. With the imposition of forward guidance, Mr Bernanke has prescribed the economic patient a new set of monetary pills.
But just as QE came with side-effects, might we eventually discover that forward guidance also has its problems? After all, it only really works if members of the public believe the central bank’s view of the future and if those members of the public believe that other members of the public also believe the central bank’s view of the future (in other words, it works on the basis of Keynes’ beauty parade). At the very least, then, forward guidance is a fragile exercise in second-guessing.
Guessing, however, is not a good foundation for monetary policy. Despite the Fed’s best efforts, however, it’s difficult to see how guesswork can be removed altogether. Before the financial crisis, central banks were keen to offer maximum monetary “transparency”. Forward guidance and transparency, however, are not happy bedfellows.
The opaque nature of forward guidance relates in part to time and economic reality. Is forward guidance a promise not to raise interest rates until a certain date or, instead, is it a promise not to raise interest rates until certain economic conditions are met? The Fed’s statement suggests the latter. Defining those conditions, however, is hardly straightforward. We now learn that the 6.5 per cent unemployment rate threshold is only a “soft” target, with the FOMC judging that “it likely will be appropriate that to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal”.
That all sounds very dovish. What the Fed has not clarified, however, is the causal relationship between unemployment and inflation, a relationship that depends on the nature of the western world’s post-financial crisis economic funk. Typically, we tend to think that inflation is a lagging indicator relative to unemployment: demand picks up,the jobless rate falls, wages accelerate and prices eventually rise. On that basis, a big drop in unemployment is an early warning sign of higher inflation in the future, leading markets to anticipate a tightening of monetary policy.
In a post-financial crisis world, however, the causality may be reversed. Weak credit growth – reflecting either a weak banking system or persistent deleveraging – pushes inflation below target which, in turn, raises real interest rates (at the zero rate bound), pushes up real levels of debt and triggers further deleveraging.
Under those circumstances, a fall in unemployment might be merely a cyclical accent within a story of underlying structural decline. This, after all, was the Japanese experience in the mid-1990s, when a modest economic recovery did nothing to prevent deflation from taking hold.
Which of these stories is relevant for the US is, at this stage, unclear. And that, ultimately, is the weakness with forward guidance. The Federal Reserve can’t make convincing promises because, like the rest of us, it doesn’t have a perfect crystal ball. But if those promises aren’t convincing, it’s not clear whether the real economy risk aversion which has limited the pace of recovery in the US will go away any time soon.
The writer is HSBC’s chief global economist and author of When the Money Runs Out
At the same time, however, the Fed has strengthened its “forward guidance” message. Simply put, America’s central bank is promising low interest rates for longer. If the Fed’s forecasts are to be believed, rates will now be 25 basis points lower than previously projected at the end of both 2015 and 2016. Mr Bernanke has even managed to ease some of the tensions that had muddied the Federal Open Market Committee’s message over recent months. Those members who had previously offered a more hawkish view on interest rates appear to have had their talons trimmed.
We have, thus, shifted from one course of monetary drugs to another. The side effects from quantitative easing were becoming troublesome: the Fed’s rapidly-expanding balance sheet was raising eyebrows in Congress; financial assets were becoming ever-more expensive even as the pace of economic recovery remained lacklustre; and hot money flows globally were reigniting imbalances in parts of the emerging world.
The Fed recognised much of this earlier in the year but, at that stage, hadn’t quite worked out a strategy to avoid the onset of post-QE cold turkey. With the imposition of forward guidance, Mr Bernanke has prescribed the economic patient a new set of monetary pills.
But just as QE came with side-effects, might we eventually discover that forward guidance also has its problems? After all, it only really works if members of the public believe the central bank’s view of the future and if those members of the public believe that other members of the public also believe the central bank’s view of the future (in other words, it works on the basis of Keynes’ beauty parade). At the very least, then, forward guidance is a fragile exercise in second-guessing.
Guessing, however, is not a good foundation for monetary policy. Despite the Fed’s best efforts, however, it’s difficult to see how guesswork can be removed altogether. Before the financial crisis, central banks were keen to offer maximum monetary “transparency”. Forward guidance and transparency, however, are not happy bedfellows.
The opaque nature of forward guidance relates in part to time and economic reality. Is forward guidance a promise not to raise interest rates until a certain date or, instead, is it a promise not to raise interest rates until certain economic conditions are met? The Fed’s statement suggests the latter. Defining those conditions, however, is hardly straightforward. We now learn that the 6.5 per cent unemployment rate threshold is only a “soft” target, with the FOMC judging that “it likely will be appropriate that to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal”.
That all sounds very dovish. What the Fed has not clarified, however, is the causal relationship between unemployment and inflation, a relationship that depends on the nature of the western world’s post-financial crisis economic funk. Typically, we tend to think that inflation is a lagging indicator relative to unemployment: demand picks up,the jobless rate falls, wages accelerate and prices eventually rise. On that basis, a big drop in unemployment is an early warning sign of higher inflation in the future, leading markets to anticipate a tightening of monetary policy.
In a post-financial crisis world, however, the causality may be reversed. Weak credit growth – reflecting either a weak banking system or persistent deleveraging – pushes inflation below target which, in turn, raises real interest rates (at the zero rate bound), pushes up real levels of debt and triggers further deleveraging.
Under those circumstances, a fall in unemployment might be merely a cyclical accent within a story of underlying structural decline. This, after all, was the Japanese experience in the mid-1990s, when a modest economic recovery did nothing to prevent deflation from taking hold.
Which of these stories is relevant for the US is, at this stage, unclear. And that, ultimately, is the weakness with forward guidance. The Federal Reserve can’t make convincing promises because, like the rest of us, it doesn’t have a perfect crystal ball. But if those promises aren’t convincing, it’s not clear whether the real economy risk aversion which has limited the pace of recovery in the US will go away any time soon.
The writer is HSBC’s chief global economist and author of When the Money Runs Out
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