US: When timing is all
By Robin Harding
Published: April 19 2011 23:39
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| Time has run out for questions as Ben Bernanke, Fed chairman, testifies on Capitol Hill. He sees risks to the US economy as having receded |
Just over a year ago, Ben Bernanke went to testify on Capitol Hill. The mission of the Federal Reserve chairman was to explain how America’s central bank planned to unwind the ultra-loose monetary policy that it had deployed to fight the recession of 2008-09.
Mr Bernanke’s testimony had already been published some weeks earlier. The hearing on Fed exit strategy was scheduled for early in February but postponed after some of the worst blizzards in years buried Washington under a metre of snow.
It was still not apparent on March 25 when Mr Bernanke did speak, but during those few weeks of delay at the end of winter, the ground had begun to shift under his feet. What started as a can-you-believe-it tale about official misreporting of the Greek public finances was morphing into a European sovereign debt crisis that rocked market confidence across the world. The US economic recovery – which in the spring of 2010 looked encouragingly robust – was about to stall.
Even as public debate raged last summer about whether to raise short-term rates above zero first or else sell some of the Fed’s $1,000bn in assets bought to prop up the economy, and how to drain excess cash from a banking system flooded with it, the Fed’s actual monetary policy debate was moving in the other direction. In a wrenching about-turn, the Fed switched towards easing policy again last August, and in November it began a second $600bn round of asset purchases. To the disgust of the Fed, which disputes the meaning of a type of intervention that had come to be described as quantitative easing, the latest bout of buying was nicknamed QE2 – as if it had merely launched another extravagant ocean liner.
The QE2 purchases will be complete at the end of June; that is likely to be the end of Fed asset buying. After a year in which much happened, the Fed finds itself back where it began. The economy appears to be making progress but its momentum varies like a car in traffic. Hawks on the rate-setting federal open market committee, their concerns about inflation heightened by a surge in commodity prices, want to talk about exit again.
Raghuram Rajan, professor at the University of Chicago’s Booth business school and a former International Monetary Fund chief economist, was a sceptic about QE2 but says all the Fed can do is prepare for a slow rise in interest rates. “The problem with monetary policy is that you’re imprisoned by the way you’ve talked about it and the expectations that you’ve created,” he says.
Jan Hatzius, chief US economist at Goldman Sachs in New York, is more cautious. “I think they should let QE2 expire and then basically do nothing,” he says. “I still think we’re going to be in a low-inflation environment.”
How soon the Fed follows the European Central Bank in raising rates will affect everything from the strength of the dollar to the sustainability of the US recovery. QE2 prompted a rally in almost every global asset market and their fate after its conclusion is uncertain. The rest of 2011 is likely to bring rising tension as the Fed prepares its exit strategy again but tries to avoid its mistake of letting preparations be seen as a signal that exit is imminent.
Understanding why the Fed launched QE2 last November makes it clear why even the more dovish members of the FOMC are not pushing for more asset purchases now. “With job creation stalling, concerns about the sustainability of the recovery increased. At the same time, inflation – already at very low levels – continued to drift downward,” Mr Bernanke explained on his most recent visit to Congress last month.
A negligible risk of deflation means there is little case for further asset purchases, although if there were a shock that again halted the recovery and pushed inflation to new lows, a large majority of the FOMC would consider fresh action. The biggest recent shock is the jump in oil prices to above $100 a barrel but, at present, that looks more likely to slow the recovery than to stop it. Higher commodity prices will not “greatly impede the economic recovery” unless they go further, Janet Yellen, Fed vice-chair, said recently.
That downward drift was very important. The Fed launched QE2 not because unemployment was high and inflation was below its goal of “2 per cent or a bit below”. It acted because unemployment was becoming no better and inflation was moving away from its objective – creating the risk of a slide into outright price declines that could have dragged the US into a Japanese-style lost decade.
Things are different now. The unemployment rate has fallen by a full percentage point in recent months to 8.8 per cent and job growth is tolerable. Core inflation, excluding food and energy prices, hit a trough last December with a year-on-year rise of 0.7 per cent and has since bounced back to about 1 per cent. A host of secondary indicators – from new claims for unemployment insurance to manufacturing orders to growth in consumption – suggest that the economy is moving forwards even if it has stumbled again in recent weeks.
“We have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold,” Mr Bernanke said in March. “Downside risks to the recovery have receded and the risk of deflation has become negligible.”
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At the heart of the FOMC’s debate in the coming months, therefore, will be when and how fast to exit. In one sense, exit will start the moment the Fed stops buying long-term bonds, because the Treasury will continue to issue more of them. The central bank’s share of the total – and therefore its influence on long-term interest rates – will start to decline. But the actual decision it must make is when to raise rates. At the moment, the target federal funds rate is set at 0-0.25 per cent, but the Fed also has about $1,600bn in extra long-term assets on its balance sheet, with more to come before the end of QE2.
A Fed rule of thumb is that buying an extra $200bn of assets is the same as taking 25 basis points off the funds rate. That means current interest rates are, in effect, about minus 2 per cent. The question is when they need to move higher.
In making that judgment, the basic guideline for most officials will be some kind of policy rule that links interest rates to the amount of spare capacity in the economy and how far inflation is off target. Much depends on circumstances, and policy rules come in many different flavours, but simple examples used by the Fed suggest a need to tighten policy by the time the unemployment rate reaches 8 per cent and core inflation hits 1.5 per cent – and probably somewhat sooner. Many differences between policymakers rest on how soon they think the economy will reach this point.
But there are other concerns. One is the jump in commodity prices that has pushed up the headline consumer price index, including food and energy, by 2.7 per cent on a year ago. Some hawks think that the FOMC should respond directly to higher headline inflation. But the entire committee is ready to react to any rise in expectations of future inflation.
Another question is whether the amount of slack in the economy is as high as the unemployment rate suggests or whether some workers are now unemployable. At the very least, caution some FOMC members in interviews with the Financial Times, the amount of slack is uncertain. “I feel more confident trying to think through what’s happening to the output gap by watching core inflation. If we see core inflation pick up, that’s a sign that the output gap is closing,” says Narayana Kocherlakota, president of the Minneapolis Fed.
A final argument made by hawks is that keeping rates low for too long is encouraging financial speculation and storing up a crisis for the future. “I do worry about market operators becoming dependent on our largesse,” says Richard Fisher, president of the Dallas Fed, noting that Fed actions had distorted the normal way in which yields vary on bonds of differing maturities. “We’ve artificially bent the yield curve and shaped the yield curve and priced the yield curve.”
The balance of the committee leans towards the doves, however, and so far they have been reluctant to turn the Fed’s conversation towards exit. One reason is that they know how much markets and economists enjoy talking about it.
Exit strategy is the monetary economist’s equivalent of picking a fantasy baseball team or debating what Kate Middleton will wear for the royal wedding: there are enough options and complexities for everybody to have an opinion. Last year’s debate over the details of an exit fuelled a mistaken belief this was already on its way.
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A second difference is that the Fed now has a surplus of Treasuries as well as a surplus of asset-backed securities. That means that it can speed up the automatic decline of its balance sheet by letting Treasury bonds mature as well. The larger balance sheet is also encouraging officials to reassess the use of asset sales. Charles Plosser, president of the Philadelphia Fed, has suggested tying asset sales to interest rates. For example, he suggested, the Fed could promise to sell $125bn of assets each time it raises interest rates by 25 basis points.
Still, with easing drawing to an end, it is natural to revisit exit plans. Most officials still endorse the basic sequence discussed last year: first, scrap the promise of ultra-low rates for an “extended period”, then drain reserves out of the banking system, raise short-term rates and only after that begin sales from the asset portfolio. Mr Kocherlakota argues that tightening policy will happen via interest rates and shrinking the balance sheet can be kept separate.
Having an extra $600bn of Treasury securities as a result of the current round of asset purchases does, however, make a few differences. First, it will take longer to get rid of all of the Fed’s QE assets. For example, if disposals ran at $100bn a quarter, it would take an extra year and a half to get rid of the $600bn.
It may therefore make sense to reduce the balance sheet earlier or faster. One way to do that is to stop recycling early repayments from the Fed’s portfolio of asset-backed securities – which it receives when someone pays off their mortgage early – into new investments. If the Fed can convince markets that doing so is not a signal that it plans an early rise in rates, the FOMC may want to take this step soon after completing QE2.
The new debate about exit will not start in earnest until the Fed finishes easing policy at the end of June – but it is likely to be every bit as intense as it was last year. As Mr Fisher from Dallas says of quantitative easing: “It has been very restorative but the question is how long this goes on.”
CONSENSUS COMMITTEE
America’s rate-setting federal open market committee is bigger than most monetary policy committees. Voting membership comprises seven Federal Reserve Board governors, including the US Fed chairman; the New York Fed head; and four of the 11 other regional Fed presidents on annual rotation. The FOMC works by consensus, deferring to the Fed chairman, though members argue hard for their view of the economy.
America’s rate-setting federal open market committee is bigger than most monetary policy committees. Voting membership comprises seven Federal Reserve Board governors, including the US Fed chairman; the New York Fed head; and four of the 11 other regional Fed presidents on annual rotation. The FOMC works by consensus, deferring to the Fed chairman, though members argue hard for their view of the economy.
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COMMUNICATIONS SHIFT
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‘If you don’t explain things, someone will explain them for you’
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The shock to markets during last summer’s switch back from exit strategy to even looser monetary policy was exacerbated by the Federal Reserve’s unclear communication.
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Hawks and doves on the rate-setting federal open market committee proffered a cacophony of different interpretations, prompting sharp moves in US Treasury bond prices.
.
The US central bank’s silence after it announced a second round of quantitative easing last November also helped opponents of the policy – from conservative Republicans to foreign governments – to paint the asset purchase programme as risky, irresponsible and unnecessary.
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Now the Fed has come up with an answer to its problem. From the end of April, chairman Ben Bernanke will talk directly to the media. The FOMC updates its economic forecasts at four of its eight annual meetings; it will follow those updates with press conferences, as other central banks do.
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“It is an addition to transparency,” said Richard Fisher, president of the Dallas Fed, who was part of the FOMC working group that came up with the plan. “If you don’t explain something then someone will explain it for you.”
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Officials hope the press conferences will also draw attention to their forecasts and show how policy decisions are linked to what they expect for the economy.
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Forecast publication will be brought forward to the day of a decision. At present, they are part of the meeting minutes, which are published with a three-week delay.
.
This is more than a change to Fed communications. By drawing attention to its numerical forecasts, the bank is taking a baby step towards a more systematic and transparent policy framework – something that Mr Bernanke has long advocated.
.
The conferences will make subtle differences to other Fed communications. Minutes will matter less; and, with a chance to quiz Mr Bernanke directly, the media may grow less interested in his testimony to Congress.
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Markets may also become less inclined to mine the speeches of other FOMC members for policy clues – though, with Mr Bernanke setting out an official line on behalf of the committee, regional Fed presidents may feel free to stake out even stronger public positions of their own.
.
No other changes are likely in the short term but the communications working group will not disband, and will continue to study how to make published forecasts more informative.
.
Mr Bernanke’s long march towards a more explicit policy framework at the Fed is set to continue.
.
‘If you don’t explain things, someone will explain them for you’
.
The shock to markets during last summer’s switch back from exit strategy to even looser monetary policy was exacerbated by the Federal Reserve’s unclear communication.
.
Hawks and doves on the rate-setting federal open market committee proffered a cacophony of different interpretations, prompting sharp moves in US Treasury bond prices.
.
The US central bank’s silence after it announced a second round of quantitative easing last November also helped opponents of the policy – from conservative Republicans to foreign governments – to paint the asset purchase programme as risky, irresponsible and unnecessary.
.
Now the Fed has come up with an answer to its problem. From the end of April, chairman Ben Bernanke will talk directly to the media. The FOMC updates its economic forecasts at four of its eight annual meetings; it will follow those updates with press conferences, as other central banks do.
.
“It is an addition to transparency,” said Richard Fisher, president of the Dallas Fed, who was part of the FOMC working group that came up with the plan. “If you don’t explain something then someone will explain it for you.”
.
Officials hope the press conferences will also draw attention to their forecasts and show how policy decisions are linked to what they expect for the economy.
.
Forecast publication will be brought forward to the day of a decision. At present, they are part of the meeting minutes, which are published with a three-week delay.
.
This is more than a change to Fed communications. By drawing attention to its numerical forecasts, the bank is taking a baby step towards a more systematic and transparent policy framework – something that Mr Bernanke has long advocated.
.
The conferences will make subtle differences to other Fed communications. Minutes will matter less; and, with a chance to quiz Mr Bernanke directly, the media may grow less interested in his testimony to Congress.
.
Markets may also become less inclined to mine the speeches of other FOMC members for policy clues – though, with Mr Bernanke setting out an official line on behalf of the committee, regional Fed presidents may feel free to stake out even stronger public positions of their own.
.
No other changes are likely in the short term but the communications working group will not disband, and will continue to study how to make published forecasts more informative.
.
Mr Bernanke’s long march towards a more explicit policy framework at the Fed is set to continue.
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Copyright The Financial Times Limited 2011
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