Since the June FOMC meeting and subsequent press conference with Federal Reserve Chairman Ben Bernanke, monetary policymakers have bent over backwards to convince financial market participants that tapering quantitative easing does not imply an earlier date for the lift-off from the zero interest rate policy. It has been a hard message to sell. Gavyn Davies on the expectations shift:
One possibility is that the shock caused by the policy change has led to deleveraging by investors in panic selling of futures contracts. If so, the impact should reverse itself as the market calms down. But another possibility is that the markets have rationally taken the Fed statements on tapering as a signal that their thinking on monetary policy is changing. This signal of Fed intentions may be more powerful than the other forms of forward guidance they have given about their intentions.
When I read the latest speech by New York Federal Reserve President William Dudley, it seems evident to me that there has indeed been a shift in monetary policy. The key sentence is this:
Taken together, the labor market still cannot be regarded as healthy. Numerous indicators, including the behavior of labor compensation and household assessments of labor market conditions, are all consistent with the view that there remains a great deal of slack in the economy.
The Fed adopted a 7% unemployment trigger for ending quantitative easing despite full recognition that a wide array of labor market indicators reveal a persistently weak and under performing labor market. Moreover, they adopted the trigger in the face of decidedly weak inflation data. Why act to reduce accommodation when the Fed is missing so badly on both sides of its dual mandate? Presumably because happier days are on the horizon. Back to Dudley:
My best guess is that growth for all of 2013, measured on a Q4/Q4 basis, will be about what it has been since the end of the recession. But I believe a strong case can be made that the pace of growth will pick up notably in 2014.
The Fed intends to reduce accommodation now to prevent overheating in 2014. In effect, it is a promise to be responsible. But quantitative easing was always something of a promise to be irresponsible - the more quantitative easing, a higher proportion of the balance sheet increase would be permanent, thus raising the expected price level in the future. By pulling back on asset purchases well before labor market conditions are healthy, the Fed is reducing the odds of such overshooting. Such is the act of the responsible central bank.
If the Fed is now a responsible central bank, should it be expected to maintain zero-interest rates well into 2015? Financial markets think the answer is "no," despite the Fed's statements otherwise. And possibly the answer is "no" with good reason. Peter Stella argues here that the Fed's stated expected interest rate path is inconsistent with having a neutral Federal funds rate when the economy reaches full employment:
...we seem compelled to adopt a “baseline” scenario, perhaps one day to be dubbed the “Bernanke stride”, consisting of a series of consecutive 25 bps target increases, one per meeting. Thus starting in mid 2015 we would end up at 400 bps by mid 2017. Again, two full quarters after unemployment had reached the “full employment” level rather than the theoretical optimum outlined above of 4 to 6 quarters before unemployment is projected to reach the full employment level.
Thus, the Fed's expected rate path is something of a puzzle:
Summarizing the puzzle, how do we reconcile a clear intention to start rate increases in mid-June 2015, the lagged impact of monetary policy, a forward-looking FOMC, the Bernanke stride, and expectations that the full employment unemployment rate will be attained by end 2016? In other words, why does it seem the FOMC aims to attain a 4 percent fed funds rate 6 to 8 quarters later than would seemingly be necessary to glide gracefully into equilibrium at potential output at the start of 2017?
His preferred explanation of the puzzle:
The most intriguing and in my view most consistent explanation of the puzzle is that the FOMC may be attempting to follow the guidance of the author of the keynote paper presented at the last annual Federal Reserve Bank of Kansas City Jackson Hole Symposium, Michael Woodford...concludes that the Federal Reserve would be better off following a policy rule that involves making up for past accumulated shortfalls in nominal output growth. That means, to return to the automotive analogy, that the central bank would compensate for a period when the economic engine was running at less than full capacity with a period of running the engine at greater than full capacity so as to “catch up” for lost time.
Of course, the challenge is convincing market participants that the Fed's intends to allow for such catch-up, effectively a period of irresponsible behavior from a conventional central banking perspective. Arguably, one means of establishing this intent was quantitative easing, which, as Davies notes, might have been the Fed's most powerful communications tool. By signalling an end to quantitative easing while the economy is still mired in a challenging economic environment, the Fed effectively communicated an intention of being responsible, and thus signaled that they would mostly likely choose to be responsible with interest rate policy as well, regardless of efforts to convince us otherwise. As always, actions are more powerful than words.
What then, would ultimately convince market participants to expect the first rate hike to be delayed until deep into 2015? Perhaps a revision of the Evan's rule to a 5.5% unemployment threshold, as Davies suggests. More powerful, however, would be an increase in the pace of quantitative easing, something that was not out-of-the-question prior to June 19 given the inflation data. At this point, such an outcome seems highly unlikely.