Whether the optics of a jobs-related target for the Fed's QEternity are election-based public relations, from-the-heart sentiment of an ivory tower academic neck-deep in the reality of his failed ethos, or well-intentioned more-of-the-same Krugmanite 'we need a bigger boat' print til-we-stink policy; it is relatively clear that the Fed has changed course. The longstanding problem at the Fed has been that while each policymaker more or less agreed that guiding policy by a rule made sense, they could not collectively agree on the rule. Morgan Stanley's Vince Reinhart notes perfectly that at its September meeting, the Fed effectively evaded the issue by setting QE off in a general direction, much in the same way Columbus pointed his three ships West and expected eventually to land in India. The history books admire the audacity of a man with a vision. Columbus sailed in the direction toward the known world’s end. Of course, he also sailed further than expected and landed on a completely different continent than planned. If the Fed has not acted consistently over the past few meetings, how will market participants infer future action?
Morgan Stanley: Charting the Course
Most analyses of unconventional central bank action agree that policy works best if it links the instrument reliably to economic data or forecasts. The logic of such conditional policy rules (also known as open-ended programs) was worked out in Bernanke and Reinhart in 2004 and has been a running theme in the work of Michael Woodford, who summarized this view at Jackson Hole.
The fixed point on the Fed’s compass is jobs. As its statement related,
“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.”
Market participants will be able to price expected future Fed actions only to the extent that the Fed acts consistently. The same two reasons why we were wrong about the Fed’s willingness to launch QE3 worry us about how the Fed plots its course.
- We thought that the Fed thought it acted appropriately in June. Policymakers had the opportunity to reset the monetary policy bar in June. They chose to extend Operation Twist until year-end. This seemed to us to show that the Fed was resigned to poor economic performance because that policy initiative neither pulled the unemployment rate below its long-term norm nor pushed inflation up to its goal. To accept this outcome revealed doubts either about the efficacy of or its ability to use its policy instruments. Between the June and September meetings, data disappointed. The Fed’s own Survey of Economic Projections (SEP) puts the central tendency of GDP growth for 2012 three-tenths percentage point lower over those months. But the complete picture is more mixed. The traditional inputs in monetary policy rules – the unemployment and inflation rates – are, respectively, unchanged and three-tenths higher in the SEP. Meanwhile, financial conditions eased considerably, more on the back of the assurances of ECB President Draghi than those of Chairman Bernanke. With the economy no worse and financial conditions easier than in June, the Fed nonetheless provided more policy accommodation in September. Take your pick, either the old stance of policy or the new one is wrong.
- We thought that they had an intelligent plan for December. In its decision to extend Operation Twist to year-end, the Fed created a perfectly unobjectionable opportunity to revisit the size and composition of its balance sheet at its December meeting. Part of the Fed’s current legitimate concerns about the economic expansion traces to the ongoing strains spawned by the sovereign and banking crises in Europe and the elevated risk of a sudden stop in the US federal budget on New Year’s day. At their December meeting, Fed officials will know a lot more about both as the ECB translates words into action and the US election puts the fiscal cliff in stark relief.
Even more important, delaying a decision on the balance sheet would have given Fed officials a bit more time to hammer out a compromise on coherent conditioning language to tie action to the economic outlook.
Conclusion
The history books admire the audacity of a man with a vision. Columbus sailed in the direction toward the known world’s end. Of course, he also sailed further than expected and landed on a completely different continent than planned.
If the Fed has not acted consistently over the past few meetings, how will market participants infer future action? Has it adapted a hierarchal mandate in which it will work first to reduce unemployment until it reaches some barrier of distaste on inflation? Or was the phrase “in the context of price stability” snuck in to trump policy activism?
We shall trust them by their works, which will be learned in the fullness of time.