Minneapolis Federal Reserve President Narayana Kocherlakota's recent speech made clear that a full understanding of the cost/benefit trade-off for quantitative easing is a missing piece in the communication strategy. Frustratingly, he didn't try to fill it, which leaves me hoping the incoming Chair Janet Yellen will do so in tomorrow's Senate confirmation hearings. That, however, is not likely to happen, as she will likely restrain her comments such that we learn little we don't already know.
Kocherlakota describes a goal-oriented approach to monetary policy that he believes was essential to ending the period of high inflation in the 1970's and 80's:
Faced with this challenging issue, the FOMC followed what I would term goal-oriented monetary policy. This approach had two parts. First, the Committee formulated and communicated a clear goal: It intended to bring inflation down as quickly as possible. Second, on an ongoing basis, the Committee did whatever it took to achieve that goal, even if those actions had short-term economic costs.
What this means for policy in the current context:
The Committee has to stick to its formulated approach—that is, it must do whatever it takes to achieve its communicated goal...
...Doing whatever it takes in the next few years will mean something different. It will mean that the FOMC is willing to continue to use the unconventional monetary policy tools that it has employed in the past few years. Indeed, it will mean that the FOMC is willing to use any of its congressionally authorized tools to achieve the goal of higher employment, no matter how unconventional those tools might be.
Confusion arises when one realizes the Fed does not intent to use all of its available tools to meet its goals. In particular, there is no inclination to expand the pace of asset purchases, and is instead every inclination to end the program. They are looking forward to normalizing policy by shifting the focus to forward guidance on interest rates. From Atlanta Federal Reserve President Dennis Lockhart:
In the toolkit the FOMC has at its disposal, there is a sense in which asset purchases and low policy rates are complementary. Asset purchases and forward guidance on interest rates are complements in the sense that they are both designed to put downward pressure on longer-term interest rates...
...But there is also a sense in which these tools are substitutes. By substitutes I mean that guidance pointing to a sustained low policy rate and asset purchases are discrete tools that can be deployed independently or in varying combinations. They can be thought of as a particular policy tool mix chosen to fit the circumstances at this particular phase of the recovery...
...Going forward, it may be appropriate to adjust the policy tool mix. That will depend on circumstances and the economic diagnosis of the moment.
The challenge has been convincing financial markets that tapering is not tightening or a signal to future tightening. Why has this been a challenge? Presumably because the Fed has not done a good job as explaining the need for a change in the policy mix. Back to Kocherlakota:
The Federal Open Market Committee is currently buying $85 billion of long-term assets per month. Recently, there has been an ongoing public conversation about the possibility that the FOMC might reduce its current flow of long-term asset purchases over the next year. The FOMC’s asset purchases push down long-term interest rates, and encourage consumers to spend and businesses to invest. Hence, reducing the flow of purchases in the near term would be a drag on the already slow rate of progress of the economy toward the Committee’s goals. From the perspective of a goal-oriented approach, the timing of this conversation seems puzzling.
The tapering discussion appears ill-advised given that unemployment remains unacceptably high and inflation remains unacceptably low. Indeed, given the Fed's own forecasts, there is little reason to tempt fate by changing the policy mix in any way that could be interpreted as a prelude to tighter policy. Kocherlakota, however, points out the Fed's escape clause:
I find that the FOMC’s statement, released after its recent meeting, provides a useful way to understand this otherwise puzzling conversation. Long-term asset purchases are still a relatively novel tool, and central banks continue to learn about their costs and benefits. For this reason, the FOMC statement emphasizes that its decisions about asset purchases are based not only on the Committee’s economic outlook, but also on its assessment of the costs and efficacy of this unconventional policy tool. The requisite calculus is necessarily a delicate one.
The tapering debate is centered largely on the issues of "stronger and sustainable" labor market data and "progress" toward goals. With these criteria in mind, it seems difficult to justify tapering, yet we continue to expect tapering because policy makers keep emphasizing the need to change the mix of policy. Hence confusion over the intentions of the monetary policy makers. And Kocherlakota sees the fundamental source of the confusion:
Unfortunately, the recent public conversation about reducing the flow of asset purchases typically places little or no emphasis on these costs and efficacy considerations. As a result, the dialogue risks creating the perception that the Committee is not following a goal-oriented approach to monetary policy. Such a perception can create doubts and uncertainty about the criteria underlying Committee decisions. We can see the imprint of those doubts and uncertainty in the heightened level of bond market volatility over the past few months. I believe that the Committee could reduce this volatility by greatly enhancing its communication on the role of cost and efficacy considerations in its deliberations about the evolution of asset purchases.
We seem to be missing an explicit discussion of the cost/benefit tradeoff. We think it has something to do with financial stability issues, policy exit issues, political implications of an ever expanding balance sheet, etc. But we have no clear metrics to evaluate these issues; all we really know is that policymakers are sufficiently uncomfortable with the asset purchase program that they are looking to end it.
One would think that Kocherlakota, having elevated the issue to something that demands a response, would then seize on the opportunity to explain the "cost and efficacy considerations" in play. No such luck, as he instead pushes forward to other communication changes, such as lowering the unemployment threshold, and the possibility of reducing interest on reserves as tools by which the Federal Reserve could pursue its goal oriented strategy.
Thus even arch-dove Kocherlakota, it seems, has lost interest in asset purchases, yet, almost maddenly, fails to explain why the cost/benefit calculus has turned against continued asset purchases. It is as if he knows the answer, but is simply not willing to say it without official FOMC guidance. There seems to be a lack of transparency here. The Fed simply is not fully explaining the standards by which it is evaluating the asset purchase program. It is kind of like subjecting financial market participants to "double-secret probation" regarding the path and timing of tapering.
Bottom Line: The Fed is clearly signalling they want to change the policy mix. They are not clearly signalling why. Kocherlakota effectively makes clear that the "why" has to do with the cost/benefit calculus surrounding asset purchases. I would very much like Yellen to explain that calculus in her Senate hearing, and wish someone would ask the question directly. Probably not gonna happen.