Easing Seems Likely, But of What Form?, by Tim Duy: The Federal Reserve meeting is bearing down upon us. We have witnessed a variety of Fed views across the spectrum over the past two weeks presenting a number of options: Continue Operation Twist, expand balance sheet operations, extend the forward guidance, other non-specified communication tools, or just plain do nothing. I would say on net the balance of talk leans toward some kind of action, although we do not know the intentions of Federal Reserve Chairman Ben Bernanke. There was no strong hint in his testimony last week. Given his revealed preferences over the past six months, I tend to believe that he is hesitant to undertake additional balance sheet operations at this time. I don't think he sees the appropriate risk/reward trade off for such an action. An extension of Operation Twist (limited though by the Fed's dwindling supply of short-term securities) seems to be a reasonable middle ground (I was probably a little pessimistic on this point last week), as it at least doesn't move policy backwards.
Last week, San Francisco Federal Reserve President John Williams presented a rather dour economic forecast:
Putting it all together, my forecast calls for real gross domestic product to expand at a moderate pace of about 2¼ percent this year and about 2½ percent next year. I expect the unemployment rate to remain at or a bit above 8 percent for the remainder of this year, and then gradually decline to a little above 7 percent by the end of 2014.
More important for policy is his view of the risks to that forecast:
However, the uncertainty around this forecast is great.
Notably, not only is the uncertainty great, he appears to believe that the vast majority is tail risk on the wrong side of his forecast. Europe featured prominently as a risk, with his conclusion:
Recurrent spikes in fear and uncertainty are followed by piecemeal actions that buy time. What hasn’t emerged is a credible, comprehensive solution to Europe’s problems.
The single biggest reason for the Fed to ease next week is the ongoing European turmoil. Reading between the lines, it seems clear that Williams - and I suspect this sentiment is pervasive on Constitution Ave. - believes the Europeans are generally clueless and institutionally incapable of resolving their crisis. If the Fed believes Europe is on the fast track to economic depression, the rational response is to act now to cushion the blow to the US.
Yesterday, Williams widened his scope:
While the global financial system is stronger than it was three years ago, it remains vulnerable. The European sovereign debt crisis threatens banks in that continent, and, by extension, elsewhere. Clearly, it represents a significant threat to financial stability. In the worst case, the European crisis could undermine the financial improvements in North America and Asia. But this crisis is by no means the only risk. Economic trends in many parts of the world appear to be deteriorating. Although growth in the United States remains moderate, Europe looks to be in recession. And, in China, recent indicators point to a marked deceleration in growth. Many large global financial institutions remain highly leveraged and rely on volatile wholesale funding. Others are still working through troubled loan portfolios. Efforts by regulators to close loopholes exposed by the crisis remain a work in progress. They will take years to complete.
In other words, the world has only deteriorated further in the last week. How should the Fed respond? Williams was a little cagey last week:
In sum, I see the Fed falling short on both our maximum employment and inflation mandates for some time. And the turmoil in Europe and government fiscal retrenchment in the United States raise the danger that the economy could perform worse than I expect. For these reasons, it’s crucial that we maintain our current highly stimulatory monetary policy stance. As part of this, we’ve stated our intention to keep our benchmark short-term interest rate at exceptionally low levels at least through late 2014.
We must also stand ready to do even more if needed to best achieve our statutory goals of maximum employment and price stability....
I find this irritating - Williams sees the Fed falling short of its mandate, with the risks all on the downside, yet his response is that we should just maintain existing policy? Apparently, we need things to get worse:
...If the outlook for growth worsens to the point that we no longer expect to make sustained progress on bringing the unemployment rate down to levels consistent with our dual mandate, or if the medium-term outlook for inflation falls significantly below our 2 percent target, then additional monetary accommodation would be warranted.
What I think is going on is that, left to his own devices, Williams would have eased already, and is certainly even more inclined to do so given the deteriorating economic environment in the last week alone. He is not willing to call for additional easing directly, however, as he doesn't want to risk contradicting the decision of the FOMC.
How should the Fed proceed? According to Williams:
In such circumstances, an effective tool would be further purchases of longer-maturity securities, potentially including agency mortgage-backed securities. Past purchases have succeeded in lowering borrowing costs and improving financial conditions, thereby supporting economic recovery.
I highlight this line because it differs slightly from what Yellen said last week:
If the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective, I am convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions.
Yellen includes forward guidance as a tool, although she later notes that:
...the effects of forward guidance are likely to be weaker the longer the horizon of the guidance, implying that it may be difficult to provide much more stimulus through this channel.
The communications tool could be an alternative to balance sheet tools at this next FOMC meeting. The same thought was reiterated yesterday by Atlanta Federal Reserve President Dennis Lockhart, although he is not in the easing camp just yet:
"I don't think any of the options should be taken off the table under the current circumstances. But I'm not convinced at this moment that the circumstances quite yet call for additional action," Lockhart told reporters.
He added that an adjustment to the way the U.S. central bank communicates, as opposed to asset purchases, is a possible easing tool if needed.
As an aside, Lockhart disappoints with this:
"It remains to be seen whether that picture holds, therefore it remains to be seen whether we might need further action to sustain that level of attractive interest rates for borrowers," Lockhart said of the ultra low yields.
"It does in some respects take the pressure off, to do something about financial conditions per se," he added.
He sees lower yields as an excuse not to act. The correct response is to see yields as a signal that they should act.
My instinct is that the Fed will want to take some action at the next meeting. As a baseline, consider this concluding remark from David Altig and John Robertson:
In such an environment, it is probably good to remember that standing pat with central bank asset purchases does not necessarily mean standing still with monetary policy.
Doing nothing is not an option. But I sense they will not be eager to expand the balance sheet. I am having trouble seeing Federal Reserve Chairman Ben Bernanke as wanting to pursue the latter option without what he feels is a compelling financial or economic reason. Perhaps I am too pessimistic on this point, but whenever I read the list of current FOMC voting members I see a group of people that well before today wanted to ease more or were willing to ease more if Bernanke has pushed in that direction. It's not the official "hawks," but "hawk-light" Bernanke that is the obstacle to additional asset purchases.
The Fed could opt for a communications only strategy. But of what form would the communication take? Optimally, I would be hopeful for the state-contingent approach that Chicago Federal Reserve President Charles Evans once again promoted today:
The Chicago Fed chief again lobbied for the central bank to take more aggressive steps to stimulate growth.
The Fed’s current policy is to keep the short-term federal-funds rate near zero at least through late 2014. Mr. Evans favors “improved forward guidance” for conditions that would warrant a funds rate increase. He would like to see the Fed specify that it won’t raise the rate until the U.S. unemployment rate falls below 7%, or if inflation rises above 3%, which is above the Fed’s 2% inflation target.
A 7% jobless rate is still too high, “but it’s in the right direction,” Mr. Evans said.
A clearer policy about the Fed’s “forward intentions” for the funds rate would eliminate some of the uncertainty among hesitant entrepreneurs, he added.
The challenge I see is that I can't imagine Bernanke willing to accept inflation up to 3%. I just don't see it happening. I don't think the Fed is ready to provide guidance dependent on economic outcomes, and certainly not anything that contradicts their newly minted statement committing to a 2% inflation target.
Excluding the Evans approach, what is left? Extending the horizon of the period of low rates, which Yellen suggests is not particularly effective? Moreover, I am not sure they have enough clarity on the economic outlook to extend the horizon on exceptionally low rates, which just proves how unwieldy this tool really is. It would be so much easier to set up macroeconomic targets that would trigger a rate hike rather than an arbitrary time frame. Possibly just a sternly worded easing bias given the prevalence of downside risks? I do worry that the latter is all we will get next week.
Bottom Line: The Fed is running out of room to maneuver in the absence of expanding the balance sheet further. And I don't see that Bernanke wants to take that road in the absence of a more significant downturn in the economy. They can continue Operation Twist, but they have limited room on that front given the dwindling supply of short-term assets. Some sort of communication tool is also on the table. Absolutely nothing is not really on the table. So my expectations at this point, in order of likelihood are: 1.) Continue Operation Twist , 2.) communicate a clear easing bias with a hair-trigger, 3.) combine communication with continuing Operation Twist, making is clear that if conditions deteriorate further, Operation Twist will be converted to outright asset purchases when the scope for twisting ends, or 4.) additional asset purchases.
Sorry for the long post; this is a tough nut to crack. Too many options; this was easier when it was all about 25bp.