Fed Watch: Too Little

Sudeep Reddy reports on the Fed's plans for another round of quantitative easing:

The Federal Reserve is likely to announce a new bond-buying program next week structured around smaller purchases that can be adjusted over time, rather than the shock-and-awe approach it employed in 2009. It’s a cautious strategy that considers the uncertainty around both the pace of the recovery and the costs of embarking on another round of purchases.

He also notes that an old speech from Bernanke helps us to understand why the Fed is adopting a gradual approach:

...Then he [Bernanke] gets into miniature golf:

“Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won’t try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?

“Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). Gradualism in action!”

Bernanke tends to spend much of his free time watching baseball, not golf, so give him some credit for this one

But is gradualism always best? If the putt is up a steep hill and the flag is just over the crest, and there is a large flat spot behind it, gradualism is the wrong approach. In this case, you'd want to be sure to clear the crest of the hill. There's still a sense in which you would play conservatively, especially after clearing the hill, but the point is that the first shot should guard against undershooting. The putter may be deader than you expect, and to guard against this you'd want to give the putt a little extra force so as to be sure to clear the hill. If the putter turns out to be lively instead of dead and you overshoot, that's still better than an outcome where the ball rolls all the way back down the hill and you have to try it all over again.

This has come up before. As I noted in January 2009 during the debate over the size of the fiscal stimulus package:

the stimulus package is like driving up an icy hill. If you don't have enough momentum from the start and fail to provide enough "stimulus" to get the car over the crest of the hill, you can slide all the way back to the bottom, crashing into things along the way and end up worse off than when you started. Maybe you can give it more gas along the way if needed without spinning out, and perhaps you can hold your position if you don't make it to the top, and then start again from the higher level. But that's not a chance I want to take when I'm sitting at the bottom wondering if I can make it to the top without wrecking my car. The possibility of falling all the way back to the bottom and ending up worse off would make me want to start with sufficient momentum and then some.

Gradualism is not always the best approach (even in miniature golf). As Paul Krugman said recently in response to a Bernanke speech indicating that the Fed is likely to be cautious in implementing unconventional policies such as quantitative easing, "half-hearted measures are a good way of guaranteeing that unconventional policy fails."

A defense of the gradualist approach comes from Jim Bullard, president of the St. Louis Fed, in an email responding to Tim Duy's opposition to a "disciplined" QE program:

...on the "disciplined" QE program: The quote from Vince Reinhart, who is a great guy, gives the "shock and awe" view of QE. I do not think this is remotely correct. We know how monetary policy works: through the expected future path of policy, not through the actual move on a particular day. When we make 25 basis point moves on the federal funds rate, those are small viewed in isolation, but they have important effects for macroeconomic stabilization because they imply an expected interest rate path over the coming years. The same is true for QE. A move on a particular day may seem small, but it implies a path for future policy, and a series of smaller moves may add up to a very large move if the incoming data are consistent with such an outcome. The "shock and awe" view, if applied to interest rate targeting, would suggest very large interest rate movements in response to relatively small changes in incoming data, a policy that most would view as destabilizing for the macroeconomy. The same is true for QE. So the point is that QE moves should be commensurate with the incoming data (a.k.a. "state contingent"). Of course we can argue about the incoming data--and I know you have strong views on that--but I think my position on a "disciplined" QE program is correct and that the dangerous policy is to make destabilizing moves out of line with the incoming data.

Here's the Reinhart quote Bullard refers to:

I think Chairman Bernanke probably disagrees [that the Fed is out of ammunition] on two main counts. One is there's still communication. The Fed could convey they're going to keep interest rates low for a very long time. They've probably done as much as they can on that front. They maybe could do a little bit more. But that leads to one other option, which is buying stuff, buying Treasury securities. Now, Alan Binder I think, believes that that effect isn't that great, but the way you get around that is to buy in very large volume..., it will have to do very large purchases of Treasury securities.

And here's Tim Duy's latest Fed Watch, which addresses this issue:

Too Little, by Tim Duy: Federal Reserve policymakers must be pleased with themselves. Market participants have fallen in line like lemmings off a cliff pursuing the obvious trades as the excitement over quantitative easing builds. Equities, bonds, commodities are all up. Dollar is down. Perhaps more importantly, measured inflation expectations have trended higher. Psychology is a powerful thing. Like leverage.

But like leverage, psychology can turn against you. The psychology of market participants forms on the back of expectations, which in this case is for the Fed to announce a significant expansion of the balance sheet on November 3. If the Wall Street Journal is correct, the Fed is poised to disappoint those expectations with an announcement of "a few billion dollars over several months." This looks like a clear effort to temper expectations.

How can Federal Reserve Chairman Ben Bernanke not view this as anything but yet another major policy error? The first supposedly "shock and awe" balance sheet expansion failed to reflate the economy. What kind of expectations should we have for the "shock and disappoint" strategy? And the stakes are even greater. Market participants already dutifully followed the first reflation attempt, and have eagerly embraced the second. Just exactly how many bites at the apple does Bernanke expect he is going to get? Fool me once….

Moreover, the Fed's communication strategy will almost certainly become more muddled in future months. A reminder from the Wall Street Journal:

In the next few months, internal opposition to Mr. Bernanke's approach could intensify as presidents of three regional Fed banks who have expressed skepticism about the plan—Narayana Kocherlakota of Minneapolis, Richard Fisher of Dallas and Charles Plosser of Philadelphia—take voting positions on the Fed's policy-making body.

To be sure, Fed policymakers will argue that they are trying to preserve flexibility. Why is it that "flexibility" means the ability to scale up? Why can't "flexibility" mean the ability to scale down? Seriously, it is not as if the Fed is in any danger of hitting either of the objectives in the dual mandate anytime soon. And does Bernanke really believe that it will be any easier to offer a credible commitment to scale up once Dallas Federal Reserve Chairman Richard Fisher is a voting member of the FOMC?

And to what extent does a smaller than anticipated QE reflect a concern about a precipitous fall in the Dollar? Is this part of the G20 "agreement" to end currency battles? Taking currency effects off the table will greatly reduce the effectiveness of any QE strategy. Does Bernanke expect to win this battle on expectations alone, without actually having to live up to those expectations?

Bottom Line: Right now, I have more questions than answers. The US economy is operating below potential to the tune of about a trillion dollars give or take. The Obama Administration is poised to turn its attention to deficit reduction, seemingly oblivious to the historical errors of Japanese fiscal policy, not to mention the US experience in the Great Depression. For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. Truly, it boggles the mind, and suggests that Bernanke is far more worried about the specter of inflation than the real pain of unemployment.