Month: March 2013
THE Federal Open Market Committee will be meeting today and tomorrow and is expected to announce a continuation of the open-ended purchases of Treasuries and mortgage-backed securities begun last year. Those purchases are a complement to the Feds new communication strategy, in which its timeline for eventual rate increases is linked to progress on the unemployment rate subject to tolerable levels of inflation.
Fed watchers will be looking for new communication tidbits this time around, however, related to the asset-purchase programme. Minutes from the last Fed meeting revealed an internal debate over just how long the Fed should keep buying, with some FOMC members in favour of maintaining purchases for all of 2013 and others supporting an end mid-year. The feeling now seems to be that the FOMC may move toward a new set of thresholds specific to QE purchases. Bill McBride quotes Goldman Sachs economist Jan Hatzius:
The rationale for QE thresholds is similar to that for funds rate thresholds, namely that they would help the financial markets understand the Feds reaction function with respect to changes in the economic outlook. If the committee adopted such an approach, the most likely thresholds would be 7.25% for the unemployment rate, 2.5% for the 1-2 year PCE inflation outlook, and well anchored inflation expectations. We would also expect an additional out, namely that QE must not impair market functioning or create financial imbalances.
Any move to QE thresholds would probably not occur until the spring or summer of 2013. But the future of QE, the criteria for slowing or ending it, and perhaps even the question of whether QE thresholds are desirable in principle are likely to be on the FOMCs agenda as soon as next week.
Mr Hatzius is right that the goal of threshold announcements for QE would be enhanced communication. But its worth asking why this is necessary. And to do that, one has to think about why the Fed is deploying these asset purchases in the first place.
Lets back up. Fed communication about its reaction function (how it will adjust policy in response to changing economic conditions) is a key part of policy-making. In doing so, the Fed aims to influence public expectations about what economic conditions to expect when: if inflation comes in above target, the publics knowledge of the Feds reaction function will lead it to anticipate tightening such that inflation comes back into line. Above-target inflation in period n willnot lead to expectations of above-target inflation in period n+1. And of course, if the public expects inflation to slow after an announcement of above-target inflation, then inflation will in fact slow. Awareness of the reaction function shapes expectations which shape outcomes.
This dynamic is especially important now, with interest rates stuck near zero. The Fed has worked hard to communicate the factors affecting its interest rate choices in order to convince the public that it will not tighten immediately when inflation rises 2%; it says, for instance, that rates will remain near zero at least until unemployment falls to 6.5% while inflation is no more than 2.5%. This inflation should communicate to the public that higher inflation looms. That, in turn, should raise inflation and reduce real interest rates now, supporting a stronger recovery. But the Fed has muddied its message by releasing economic projections for inflation at or below 2% for the foreseeable future. The general way the interest rate communications should work is clear: the Fed wants you to know what it will do under what circumstances, so that you will come to anticipate faster growth and thereby help bring faster growth about. The only trouble is that the Fed has effectively sent mixed messages about the precise speed of recovery its prepared to accept.
Given this, whats the point of the asset purchases? Typically, such purposes serve three purposes. First, they can facilitate credit easing. Buy purchasing mortgage-backed securities, for instance, the Fed may unhelp unclog the flow of credit from wary banks to would-be buyers, helping to repair one of the key monetary policy transition mechanisms. In combination with the rate-language policy, this channel carries the intended meaning, We want a faster recovery, and we want a more robust real estate investment recovery to facilitate that.
The second purpose is more like mechanical lifting of the economy. Asset purchases raise asset prices across the economy as the Fed buys securities from private investors and hands them cash, to use to go out and buy other securities. The lower rates and higher asset prices that result encourage borrowing and investment. Purchases may also reduce expected future taxes by lowering government borrowing costs, again through lower rates. In combination with the rate-language policy, this channel carries the intended meaning, We want a faster recovery, and we want a faster recovery. If that strikes you as a bit redundant, youre not alone.
The third purpose is to influence expectations. Asset purchases may reinforce the credibility of other expansionary policy. One way this might work is by increasing the Feds potential for balance-sheet losses; as it accumulates purchases, it raises its potential losses in the event that interest rates rise. Given the possible political unpleasantness that might result, a larger balance sheet is meant to serve as a commitment mechanism to expansionary policy. In combination with the rate-language policy, this channel carries the intended meaning, We want a faster recovery, and we really mean it.
So what is gained by adding language about when to expect asset purchases to end? The credit easing mechanism is targeted at easing credit and should be linked not to broad economic conditions but to conditions in the targeted credit market. The mechanical effect of asset purchases is, while not unhelpful, mostly redundantassuming that expectations are behaving as the Fed would like them to. If expectations are behaving as the Fed would like them to, then theres no need for further communication. If expectations arent responding to the Feds communicated goals, then its difficult to see how additional thresholds will help. Perhaps another layer of asset purchases could be adopted to enhance the credibility of the thresholds established for the initial asset purchases. Alternatively, the Fed might try clarifying what the it in we really mean it means.
Heres the real issue: since the Fed shifted (rightly) to expectations-based policy, asset purchases mainly serve as an exclamation point on the Feds rate communications. Theyre a bit like a kings crown; if the king has to rely on the crown to awe his foes, hes probably not conducting the rest of his business appropriately. Those communications need reinforcing in the first place because the Fed, whatever its official mandate, is assumed to be first and foremost an inflation targeter. The Fed wants more inflation without actively saying that it wants more inflation, and so its relying in part on asset purchases to do a bit of nudging and winking. Mr McBride also publishes a revealing quote from Boston Fed President Eric Rosengren:
My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.
Not just purchase assets, butforcefully purchase them (which translates into shouting on the open-market desk, I presume). And to what end? To bring down unemployment,so long as inflation and inflation expectations are well-behaved. We dont want higher inflation! But, you know, if inflation insists on being well-behaved were going toforcefully purchase assets.
Thresholds for QE will only muddy the waters unless the Fed uses them to make one thing perfectly clear: that it both wants and will work to achieve inflation temporarily above-target. The funny thing is that if the Fed manages to clear that up, then the asset purchases (to say nothing of the thresholds for when theyll come to an end) shouldnt be necessary anymore.
National#x2019;s Monetary Policy Inflicting Unnecessary Hardship
Thursday, 31 January 2013, 11:09 am
Press Release: New Zealand First Party
Rt Hon Winston Peters
31 January 2013
National#x2019;s Monetary Policy Is
Inflicting Unnecessary Hardship
First knows it. Manufacturers and exporters know it. And
today the Reserve Bank confirmed it #x2013; our seriously
overvalued dollar is damaging the economy.
Reserve Bank said the New Zealand dollar was
#x201C;over-valued#x201D; and was undermining the export sector on
which our economy is dependent.
Rt Hon Winston
Peters says it is time the Government took action and gave
the Reserve Bank the tools to tackle the over-valued
#x201C;National has made an art form of sitting
by and doing nothing about our seriously over-valued
#x201C;Prime Minister John Key and Finance
Minister Bill English have their heads in the sand if they
believe the Reserve Bank should focus its monetary policy
solely on inflation.
Aha. In his latest op-ed, John Taylor comes out as a full-fledged monetary Calvinist. No, not a disciple of John Calvin, the preacher a disciple of Calvin of Calvin and Hobbes.
Way back when, Mike Konczal felicitously made that analogy to discuss the people who were calling for a rise in interest rates despite high unemployment and low inflation a group at the time exemplified by Raghuram Rajan. For those who dont read the classics, Calvinball is a sport in which you change the rules whenever you feel like it, very much including in the middle of games.
Back then the tight-money types were inventing new and peculiar principles of monetary policy on the fly; it was obvious that they were looking for some reason, any reason, to justify a rise in rates, because, well, because.
Now Taylor is doing the same thing. He claims that he can show that the Feds low-rate policy is actually contractionary, using basic microeconomic analysis. Actually, as Miles Kimball points out, hes committing a basic microeconomic fallacy a fallacy you usually identify with Econ 101 freshmen early in the semester (and as it happens the same fallacy committed by Rajan).
For Taylor argues that low rates engineered by the Fed are just like a price ceiling that reduces the supply of loans, and therefore reduces overall lending.
Wow. No, the Feds interest rate target isnt a price control; there is no legal or other restraint on the rates lenders can charge. The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I cant think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy.
Its just bizarre, and bears no resemblance to anything a clearly-thinking economist would say.
All I can make of this is that Taylor, like Rajan, has some visceral dislike of easy-money policies, and is grasping at anything to justify his gut feelings. And that, ladies and gentlemen, is not how you do economics.