The Federal Reserve followed through largely as expected last week, adopting a very new policy regime:
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month....
...If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
The Fed delivered open-ended quantitative easing. The end of the program is to be a function of economic outcomes, not arbitrary dates. They did not specify macroeconomic targets, such as a 7% unemployment rate, but I think few expected the Fed to lock themselves into such a specific number.
There has already been much commentary on the decision (I was otherwise engaged that day, so the whirlwind passed me by). See, for example, Mark Thoma, FT Alphaville, Gavyn Davies, FT Money Supply, Scott Sumner, and Econbrowser. I would add that this policy shift indicates that Federal Reserve Chairman Ben Bernanke has repudiated at least two of his earlier views.
The first is his belief that the stock of bond purchases was more important than the flow. Obviously, the focus is now on the flow of purchases, reflecting the importance of managing expectations in the implementation of policy. The shift to a flow-based policy removes the unnecessary uncertainty surrounding the intent of policymakers that was associated with previous, stock-based policy.
Second, notice that with his new found focus on the importance of weak labor market conditions, Bernanke returns to his former self. It has long been something of a mystery of what happened to the Bernanke who offered advised to the Bank of Japan back when he was a Federal Reserve Governor. Bernanke even felt it necessary to defend himself against attacks that he had abandoned previous positions:
So the very critical difference between the Japanese situation 15 years ago and the U.S. situation today is that Japan was in deflation,and, clearly, when you’re in deflation and in recession, then both sides of your mandates, so to speak, are demanding additional accommodation. In this case, it’s—we are not in deflation, we have an inflation rate that’s close to our objective. Now, why don’t we do more? Well, first I would again reiterate that we are doing a great deal; policy is extraordinarily accommodative...I guess the question is, does it make sense to actively seek a higher inflation rate in order to achieve a slightly increased reduction—a slightly increased pace of reduction in the unemployment rate?
Back in April, Bernanke stressed that the key factor that eliminated the need for additional QE was the lack of a deflationary threat. Bernanke has apparently abandoned that view, and now pursues an even more aggressive QE program than imagined in the spring on the basis of labor market conditions. Bernanke appears to have now come full circle on the role of monetary policy in alleviating economic distress. A long, strange trip, to be sure. And one wonders if he would have made it back full circle without the persistent critiques of the certain elements of the blogging community to push him along.
Now, of course, the question is will it work? This is, of course, an experiment. I tend to think that monetary policy would be much more effective if backed by a rational fiscal policy, but at the moment central banks in both the US and Europe left to do the job by themselves. I would add that the central bank action comes at a critical time, with a weakening global economy clearly starting to drag on US activity. Which brings us to a quick data review.
First off, note that exports growth continues to decelerate:
The impact has already been evident in manufacturing surveys:
And likely in the core manufacturing data as well:
Interestingly, I have seen little commentary on the sharp decline in core manufacturing growth, but on the topic see Barry Ritholtz. The surprise decline in industrial production (partly attributed to the hurricane), could be a warning that something more serious is brewing:
I would say on net that the consumer remains subdued. Stripping out autos and gas, retail sales barely budged in August:
That said, consumer confidence was stronger, helping to close the anomalous gap between confidence on consumer spending growth:
But gas prices continue to rise, which may bite into confidence in future months:
Higher gas prices will put some upward pressure on headline inflation, which otherwise remains subdued:
Higher gas prices and the associated impact on inflation could provide the first test of the Fed's commitment to open-ended QE. The experience of the past few years, in which higher gas prices have been a drag on the economy rather than trigger broader inflation, should have served as a sufficient lesson for the Fed to not reverse course at the tiniest whiff of rising prices.
Finally, initial unemployment claims continue to move sideways, also helped along by the hurricane:
No evidence of significant labor market improvement yet.
Bottom Line: The Federal Reserve ushered in a new policy regime last week. But will it work? That part remains to be seen. While the appropriate monetary policy given the Fed's expectation of inflation below their target and persistent weakness in the labor market, they are still fighting the effects of uncooperative fiscal policymakers. For now, the best bet is slow and steady underlying growth, with the drag of the external sector offsetting some of the early improvement in housing. Should gas prices continue to rise, the Fed will quickly find their resolve tested. My expectation is that they do not fold easily; rising headline inflation will not trigger a rapid policy reversal as higher gas prices will place an offsetting weight on final demand. I would like to say that the Fed acted in time to prevent a broader slowdown, but the manufacturing data gives me pause. While I certainly see nothing that convinces me that further slowing is inevitable, the ongoing global weakness and the fiscal cliff provide me with plenty of uncertainty heading into the final months of 2012.
