FOMC participants moved their projections for growth, employment and inflation in a direction that suggests a more pessimistic outlook for the economy than at their previous meeting. Unemployment by the end of 2012 was projected at 8-8.2%, compared to 7.8-8% previously; growth was at 1.9-2.4%, compared to 2.4-2.%; and inflation 1.2-1.7% compared to 1.9-2%. However, in spite of this deterioration in economic expectations and the fact that an undershoot of the inflation target is now expected in 2012, the Fed did not embark upon more QE but merely extended Operation Twist until the end of the year (by which time its capacity to conduct such a programme will have been exhausted).
If it sounds to you as if the Fed’s action does not cohere either with Ben Bernanke’s assertion at his press conference in January that the inflation and unemployment objectives are equally important, or with the logic of the inflation target, then you would not be alone. If unemployment (presently 8.2%) is barely expected to improve before the end of the year, and inflation is expected to undershoot, why not do more?
In my notes of the past few months I have put forward a view of what the Fed has done that suggests an answer to this question. The Fed’s new communication policy has been very effective in reducing longer-term interest rates — much more so than QE. This has only become clear in the past few months, as the change in forward guidance in January allowed the effect of forward guidance to be discerned separately from the effect of OT (I had previously interpreted the flattening of the yield curve as implying poorer economic expectations on account of OT having been a disappointment to markets — because one would not expect it to achieve very much. A stated expectation that rates would stay low for a long time is not a commitment of any kind, so I thought that it would not have any effect either; but the evidence is that it has.). If I were in the FOMC’s position, I would be pleasantly surprised by how effective the change in forward guidance had been. Further, given the lag between changes in monetary policy and their effect on the economy, I would be reluctant to easy very much more unless there was a serious deterioration in the data flow, which there has not been — the new projections are based on a pretty short-term deterioration in the data flow and could be a blip. Further, the risk of a blow-up in Europe appears to be receding, which weakens the case for precautionary action. Now, the equity market crashes of the past two years suggest that the markets take a flow view of Fed balance-sheet actions — i.e. they are effective while purchases last — rather than a stock view, which the Fed holds. Hence, I would be reluctant to bring an end to OT as planned in June, but would extend it for as long as possible. This is what the Fed has done. Equally, I would not want the market to believe that I was relying only on forward guidance to keep longer-term interest rates low, because it would suggest that I was running out of ammunition (because there is presumably a diminishing marginal effect of extending the period for which rates are expected to remain exceptionally low), so I would emphasise that QE remained on the table, as Ben Bernanke did yesterday. Challenged by a questioner that, on the portfolio-balance view, there was not much that QE could achieve once long-term interest rates were already extremely low, Bernanke fell back on another justification for QE — the money-flow view, that money used by the Fed to buy government securities is reinvested in other assets such as corporate bonds and hence finds its way into asset markets and the real economy — that I have been suggesting for some time is one of the genuine channels by which QE works (I think portfolio-balance is pretty-much irrelevant, and that expectations and money-flow are the important channels). The upshot of all this is to say that Bernanke’s actions yesterday cohered well with my view of what monetary policy can achieve in the present environment and how it has achieved it.
None of this is to say, however, that the Fed has not moved towards easing. The statement said that the committee would take “further action as appropriate” to promote a “sustained improvement” in the labour market. Even so, I wonder whether this is such a change. We were here in January, in terms of market perception, when Bernanke effectively said that the FOMC would do more if the labour market needed it. Now, as then, we don’t know what constitutes “needing it”, although things are perhaps a bit clearer now that Bernanke has said (in April) that payrolls would have to increase at 150-200k per month to be consistent with the Fed’s forecasts. Perhaps if payrolls disappoint for another month — there is only one release before the next Fed meeting — and jobless claims continue to rise, then QE will come in August. But perhaps not. On the argument I have made, it all depends on when the FOMC judges that it has enough information about the speed of travel of the economy given the current stance of monetary policy AND sees that speed as being too slow.
Incidentally, a journalist from The Economist asked an interesting question: what does BB think that the costs of QE are? BB had said that QE had both costs and benefits and one had to take both into account. In response to the question, he said: increases in the size of the Fed balance sheet might make exit harder (some have speculated that this might mean that there is a threshold beyond which QE becomes more effective, by making exit so hard that inflation expectations increase); large Fed holdings of a particular asset impair market functioning; and financial stability issues (such as, I would suggest, a lack of high-quality collateral in the financial system).