Credibility on the Line

I was pleased to see this morning that at least one other person was as appalled as me by the Jon Hilsenrath WSJ story this morning.  Below I will cover some of the same ground as Ryan Avent, but the story deserves to be told more the once.  Simply put, the Hilsenrath piece reveals that monetary policy and communication are in complete disarray and speaks poorly to the ability of the Federal Reserve to smoothly exit this period of extraordinary accommodation.

I have long suspected the Federal Reserve was increasingly biased against QE, suggesting the bar to tapering was much lower than would have been implied by the data flow.  This is particularly the case with inflation, which has remained well below the Fed's official target.  Moreover, the talk of tapering seemed ill-timed given the calendar.  It was basically impossible to believe that the Fed could even begin to have sufficient evidence about the impact of fiscal tightening to justify tapering within the Fed's framework of "stronger and sustainable" before the final quarter of this year.  The data flow simply didn't permit it.

Now we know, however, that a cadre of governors was pushing for the end of QE due to financial market concerns. From Hilsenrath:

Privately, Mr. Stein and two other governors, Jerome Powell and Elizabeth Duke , were a driving force behind efforts to limit the program's growth, according to people involved in the deliberations. All three supported Mr. Bernanke's efforts to charge up a weak economy but were uneasy about the program's potential side effects and the growing size of the Fed's holdings.

Mr. Stein, a Harvard finance professor, focused on the risk that the Fed might stoke a new credit bubble. Mr. Powell, a former Wall Street executive, talked at meetings about developing a "stopping rule" for the program to ensure the Fed's portfolio of securities didn't get too big. Ms. Duke, a former banker, was likewise wary of making an unlimited commitment.

So policy was in fact separated from the data flow.  Or was it?  Arguably, the Fed could be invoking the "costs and benefits" clause of the statement.  But they never fully communicated that position.  Why not?  Perhaps they couldn't admit that the Federal Reserve had reached its policy limits.  Or, as is more likely, the group formulating policy is not the same as the group communicating policy:

Twelve outspoken regional bank presidents often disagree publicly on Fed policy. Those based in Dallas, Philadelphia, Kansas City and Richmond have openly opposed the bond-buying program.

Six Washington-based Fed governors, in contrast, rarely speak out publicly against the chairman or dissent at meetings. Mr. Bernanke has regular contact with the these governors, who work down the hall from him. They have voted unanimously to continue the bond-buying program since it started a year ago. 

The regional bank presidents are apparently clueless about the evolution of policy between meetings.  They are simply not directly involved in the day-to-day evolution of policy.  Worse yet, those that are involved choose to remain silent.  They do not provide the regular speeches that would serve as a baseline for either market participants or regional bank presidents.  Federal Reserve Chairman Ben Bernanke does not want to serve in this role (revealed preference), and Vice Chair Janet Yellen has gone to ground in the nomination process.

The latter opens up other can of worms.  Where does Yellen stand on QE and tapering nowadays?  Everyone assumes that she is anti-tapering at the moment, but we don't know her bar for tapering.  And, as Avent points out, notice that two of these anti-QE governors were Obama appointees.  Are more such nominees on the way? Is Yellen secretly such a nominee?  

Also, this episode makes clear that the Fed cannot credibly commit to the irresponsible behavior necessary to summon what Brad DeLong calls the "inflation expectations imp." Back to Hilsenrath:

By April more officials, including the governors, were getting worried about terms like "QE-ternity" and "QE-infinity" floating around financial markets, which suggested some investors thought the program was boundless, according to people familiar with Fed discussions. The Fed officials thought the job market had made enough progress to warrant discussing an exit.

If you want to change expectations, you had to convince participants that policy was in fact boundless, that you were prepared to do whatever it takes.  The talk of "QE-infinity" was a feature, not a bug of the policy.  That's what was holding down the term premium and keeping a lid on interest rates.  The instant everyone realized the Federal Reserve was clearly not committed to irresponsible policy, the term premium jumped up, creating a tightening of monetary conditions just as the economy was entering another budget battle.   

If he Federal Reserve was genuinely committed to implementing the dual mandate in the context of the actual and forecast data, this should never have happened given the calendar.  But it did.  Why?  Because apparently the Federal Reserve is moving to a triple mandate:  Maximum employment, price stability, and financial stability.  They just failed to communicate that last part.

 Whether you agree with QE or not, several points seem evident at this point:

1. Obama is stacking the Federal Reserve Board with anti-QE candidates.
2. The anti-QE contingent has been heavily influenced by the asset bubbles of recent years and is concerned about the financial stability implications of monetary policy.  The dual mandate is becoming a triple mandate.
3. Communication is likely to remain confusing because the regional bank presidents are largely ignorant of what is happening on Constitution Ave. except in the immediate aftermath of an FOMC meeting.
4. Points one to three above imply that the Federal Reserve cannot credibly commit to an irresponsible policy path such that inflation expectations even nudge higher.  Notice that the Fed's own forecasts still have inflation reaching target from below, not above.  They don't even believe they can push inflation higher.  Why should you?
5. The Fed desperately needs to rethink its communications strategy.  They need some central view to anchor expectations.  Arguably, this is the job for that guy with the beard.  He just doesn't want to do it.
6. If monetary policy is moving to a triple mandate, and consequently the Federal Reserve has reached the limits of what it is willing to do to support the economy, the emphasis needs to shift to fiscal stimulus in the near term.  To the extent that in the long-run there remain concerns about the cost of social security and, more importantly, health care, such concerns would be much easier to address in the context of an economy operating at full employment.
7. If fiscal policy is all we have left to push the economy back to full employment, we are in deep, deep trouble, because nothing but fiscal consolidation is coming out of this Congress or Administration.

Bottom Line:  Federal Reserve communications are in disarray in the midst of a lack of internal consensus about either the costs and benefits of QE or the parameters for ending QE.  This does not bode well for an institution that increasingly relies on forward guidance to implement policy.