Fed's Commitment In Question, by Tim Duy: The Fed's commitment to open-ended
quantitative easing is more fragile than believed. That is my first takeaway
minutes of the January FOMC meeting. My second takeaway follows from the
first: If the Fed is already wavering on the pace of quantitative easing, can
it be long before they waver on their commitment to low rates as well?
Step back to the statement from the January meeting. A central part of that
statement was this sentence:
If the outlook for the labor market does not improve substantially, the
Committee will continue its purchases of Treasury and agency mortgage-backed
securities, and employ its other policy tools as appropriate, until such
improvement is achieved in a context of price stability.
What exactly is "substantially"? We don't really know, but I would be
hard-pressed to claim that the labor market has improved substantially.
Improved, yes. Substantially, no. And the Fed seemed to agree. From the
In their comments on labor market developments, participants viewed the
decline in the unemployment rate from the third quarter to the fourth and the
continued moderate gains in payroll employment as consistent with a gradually
improving job market. However, the unemployment rate remained well above
estimates of its longer-run normal level, and other indicators, such as the
share of long-term unemployed and the number of people working part time for
economic reasons, suggested that the recovery in the labor market was far from
And I don't think the subsequently released
employment report would have altered this view substantially (there's that
word again!), so there should be no reason to worry about changing the pace of
asset purchases. But maybe instead we should focus on the next line in the FOMC
In determining the size, pace, and composition of its asset purchases, the
Committee will, as always, take appropriate account of the likely efficacy and
costs of such purchases.
One would have thought the cost/benefit analysis had been completed when the
Fed adopted open-ended QE and then followed by converting Operation Twist into
additional QE. But apparently not. The cost/benefit line is the Fed's
get-out-of-jail-free card; it allows them to unwind QE regardless of the
progress in the labor market. And this shows up in the minutes.
The discussion begins with the beneficial effects of open-ended QE.
The Committee again discussed the possible benefits and costs of additional
asset purchases. Most participants commented that the Committee's asset
purchases had been effective in easing financial conditions and helping
stimulate economic activity, and many pointed, in particular, to the support
that low longer-term interest rates had provided to housing or consumer durable
purchases. In addition, the Committee's highly accommodative policy was seen as
helping keep inflation over the medium term closer to its longer-run goal of 2
percent than would otherwise have been the case. Policy was also aimed at
improving the labor market outlook. In this regard, several participants
stressed the economic and social costs of high unemployment, as well as the
potential for negative effects on the economy's longer-term path of a prolonged
period of underutilization of resources.
But the discussion turns negative quickly:
However, many participants also expressed some concerns about potential costs
and risks arising from further asset purchases. Several participants discussed
the possible complications that additional purchases could cause for the
eventual withdrawal of policy accommodation, a few mentioned the prospect of
inflationary risks, and some noted that further asset purchases could foster
market behavior that could undermine financial stability. Several participants
noted that a very large portfolio of long-duration assets would, under certain
circumstances, expose the Federal Reserve to significant capital losses when
these holdings were unwound, but others pointed to offsetting factors and one
noted that losses would not impede the effective operation of monetary policy. A
few also raised concerns about the potential effects of further asset purchases
on the functioning of particular financial markets, although a couple of other
participants noted that there had been little evidence to date of such
...Several participants emphasized that the Committee should be prepared to
vary the pace of asset purchases, either in response to changes in the economic
outlook or as its evaluation of the efficacy and costs of such purchases
evolved. For example, one participant argued that purchases should vary
incrementally from meeting to meeting in response to incoming information about
the economy. A number of participants stated that an ongoing evaluation of the
efficacy, costs, and risks of asset purchases might well lead the Committee to
taper or end its purchases before it judged that a substantial improvement in
the outlook for the labor market had occurred.
Now, in all honesty, we should have seen this coming. Cleveland Federal
While our policies have been effective, our experience with our asset
purchase programs is limited, and, as a result, we must analyze their benefits
and costs carefully. Over time, the benefits of our asset purchases may be
diminishing. For example, given how low interest rates currently are, it is
possible that future asset purchases will not ease financial conditions by as
much as they have in the past. And it is also possible that easier financial
conditions, to the extent they do occur, may not provide the same boost to the
economy as they have in the past.
In addition to the possibility that our policies may have diminishing
benefits, they also may have some risks associated with them. I will mention
four: credit risk, interest rate risk, the risk of adverse market functioning,
and inflation risk. These and other risks are not easy to see or measure,
but they need to be taken into account when setting monetary policy.
First, financial stability could be harmed if financial institutions take on
excessive credit risk by “reaching for yield” —that is, buying riskier assets,
or taking on too much leverage—in order to boost their profitability in this
low-interest rate environment. Second, interest rate risk could arise if
financial companies are not prepared to manage the losses they might suffer by
holding too many long-term, fixed-rate, low-yield assets when interest rates
rise. Third, financial market functioning could, at some point, become distorted
as a result of the Federal Reserve's large and growing presence in
mortgage-backed securities and Treasury securities markets. And last, but
certainly not least, there is the risk that the Federal Reserve's ability to
respond to future inflationary pressures could be complicated by the size and
composition of our balance sheet....
Federal Reserve Governor
Jeremy Stein explores the issue of overheating in credit markets:
The third factor that can lead to overheating is a change in the economic
environment that alters the risk-taking incentives of agents making credit
decisions. For example, a prolonged period of low interest rates, of the sort we
are experiencing today, can create incentives for agents to take on greater
duration or credit risks, or to employ additional financial leverage, in an
effort to "reach for yield."
Robin Harding of the Financial TImes recently interviewed James Bullard, and
came away with this:
US Federal Reserve officials fear a backlash from paying billions of dollars
to commercial banks when the time comes to raise interest rates...
...Officials at the US central bank fear it could create a public-relations
nightmare after the Fed was lambasted for rescuing banks during the financial
crisis. It is one factor prompting some inside the Fed to reconsider the
eventual “exit strategy” from easy monetary policy....
...Mr Bullard said that neither interest paid to banks nor possible losses on
exit made any difference to the substance of monetary policy.
“I think it’s more just a question of the optics, and how you’re going to
play the optics,” he added, referring to the perception of losses by the central
bank. “And since it shouldn’t matter in a monetary policy sense you might as
well play the optics in a better way than the one we’ve got planned.”
Ways to play the optics include slowing the pace of asset purchases or
accelerating the pace of sales when they occur. Harding reads the minutes and
The US Federal Reserve is cooling on open-ended asset purchases as officials
grow nervous about the dangers of a bigger balance sheet.
You might find this discussion frustrating as the Fed sees a clear benefit
from QE, yet only imaginary risks. See
Matthew Yglesias. Still, some sanity prevailed:
Several others argued that the potential costs of reducing or ending asset
purchases too soon were also significant, or that asset purchases should
continue until a substantial improvement in the labor market outlook had
occurred. A few participants noted examples of past instances in which
policymakers had prematurely removed accommodation, with adverse effects on
economic growth, employment, and price stability; they also stressed the
importance of communicating the Committee's commitment to maintaining a highly
accommodative stance of policy as long as warranted by economic conditions. In
this regard, a number of participants discussed the possibility of providing
monetary accommodation by holding securities for a longer period than envisioned
in the Committee's exit principles, either as a supplement to, or a replacement
for, asset purchases.
Some participants are rightly concluding the if the Fed's switches gears on
QE too soon, market participants will get a wee bit nervous that the same will
be true for interest rates. The key sentence in the statement:
In particular, the Committee decided to keep the target range for the federal
funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally
low range for the federal funds rate will be appropriate at least as long as the
unemployment rate remains above 6-1/2 percent, inflation between one and two
years ahead is projected to be no more than a half percentage point above the
Committee’s 2 percent longer-run goal, and longer-term inflation expectations
continue to be well anchored.
A rock-solid commitment to the Evans rule, correct? But, then again, maybe
not. On to the next sentence:
In determining how long to maintain a highly accommodative stance of monetary
policy, the Committee will also consider other information, including additional
measures of labor market conditions, indicators of inflation pressures and
inflation expectations, and readings on financial developments.
"Readings on financial developments" is a pretty opened-ended concept. In
fact, one might argue that it pretty much allows the Fed to ignore the Evans
rule entirely should they sense, for example, that investors are "reaching for
yield." And where have I been hearing that lately?
In short, I question that there is an elegant way for the Fed to convince
market participants that pulling back on QE for imaginary threats in the face of
evidence of real benefits does not necessarily imply that they will also ignore
the Evans rule when faced with additional imaginary threats.
Now, you should go read
Cardiff Garcia, who is not so bleak as I, and concludes his analysis with:
But it would not mean that the Fed was preparing to undo its
thresholds approach or reverse the other changes it made in the second half of
last year. Eventually the markets would figure this out.
To which I would reply that the Fed could argue that they are not reversing
their approach, they are simply exercising the stated option within that
approach to address "readings on financial developments." Still, as Garcia
All very speculative, of course, and today’s minutes do confirm that those lingering
communications issues remain unsolved.
Bottom Line: The minutes suggest the Fed is wavering on their commitment to
QE. We should watch upcoming speeches for unequal weight in the benefits vs.
costs discussion. If the weight shifts increasingly toward costs, a change may
be close at hand. And if they exercise the cost/benefit clause to ignore the
job market clause and alter the direction of the large scale asset purchase
program, recognize that the Evan's rule also has its own open-ended clause for
the Fed to place imaginary concerns over real outcomes. After all, when you are
the central bank, what exactly does not come under the realm of "readings on