Fed Foward-Guidance Fallacies And The Untenable Status Quo

Tyler Durden's picture

The FOMC will probably reduce the pace of its asset purchase program by another $10 billion at its meeting today as it continues to move towards using forward guidance as the primary policy tool. However, as we noted in the case of the Bank of England's Mark Carney, New Fed vice-chair Stan Fischer's skepticism, and even Ben Bernanke, forward guidance is losing its luster (as it works in theory but not in practice). Bloomberg's Joseph Brusuelas warns that given the probable direction of the unemployment rate amid a structurally damaged labor market and disinflation, the Fed faces a dilemma in that the status quo is untenable and may soon be challenged by traders and investors eager to move back toward interest rate and policy normalization. Just as Carney lost his credibility, the Fed risks a lot by reversing its taper today.

Via Bloomberg's Joseph Brusuelas,

The FOMC will probably reduce the pace of its asset purchase program by another $10 billion at its meeting today as it continues to move towards using forward guidance as the primary policy tool. Investors should anticipate another statement that reflects the duality of contemporary monetary policy: the hawkish reduction in asset purchases, which reflects the Fed’s growing confidence in the ability of the economy to sustain growth near the longterm trend of 2.5 percent, coupled with dovish forward guidance designed to keep short-term rates near zero.

Hidden within the occasionally obtuse central banker language is the Fed’s need to protect price stability while acknowledging that the recent decline in the unemployment rate is threatening to prematurely upend the central bank’s forward guidance policy.

Inflation is currently running just below the Fed’s lower boundary of 2 percent. Meanwhile, the decline in the unemployment rate to 6.7 percent, mostly due to individuals leaving the workforce, is threatening to jeopardize the credibility of the new forward guidance policy.

Given the elevated level in the duration of unemployment, historic lows in the labor force participation rate and employment-to-population ratio, the Fed may be unable to deliver maximum sustainable employment anytime soon.

The poor quality of labor gains and stagnant wages are indicative of a mild case of hysteresis in the labor market, or a one-time shock that results in a temporary break.

Making matters worse is the 1.3 million people who had their extended unemployment benefits terminated on Dec. 31 last year. They join the 7 million who have already exited the workforce, placing further downward pressure on the unemployment rate.

Assuming the pre-December 2013 sixmonth average trend in employment holds near 171,000 and the January household estimate captures the exit of those 1.3 million from the workforce, then the unemployment rate may decline as low as 6.5 percent, matching the Fed’s stated unemployment threshold.

If that happens, incoming Fed Chair Janet Yellen will need to use upcoming congressional testimony and Fed speeches to convince investors that a breeching of the threshold will not mean accelerating the central bank’s timetable on raising interest rates.

Given the structural problems in the labor market, the Fed will probably use the next few policy meetings to begin to emphasize the other side of its mandate, price stability, in order to legitimize its preferred “lower for longer” policy stance.

While there will probably be no major policy shifts in the January statement, investors will scrutinize the minutes when they are released on Feb. 20 to see if potential policy changes such as reducing the employment threshold to 6.5 percent or imposing an explicit inflation floor around 1.5 percent were debated.

Given the probable direction of the unemployment rate amid a structurally damaged labor market and disinflation, the Fed faces a dilemma in that the status quo is untenable and may soon be challenged by traders and investors eager to move back toward interest rate and policy normalization.