Over the weekend I posted some questions for next year: 10 Economic Questions for 2011. I’ll try to add some predictions, or at least some thoughts for each question – working backwards – before the end of year.
Remember, I have no crystal ball and I’m sure many people will disagree. Also many of the questions are interrelated. The question on monetary policy depends on inflation (question #9) and the unemployment rate (question #6). And the unemployment rate is related to GDP growth (question #4), and on and on …
10) Monetary Policy: Will the Fed expand QE2? Will the Fed reverse any of the Large Scale Asset Purchases? Will the Fed raise the Fed Funds rate?
The choices for monetary policy used to be easy. Will the Fed raise, lower, or keep rates the same? The Fed still has those choices – although they can’t lower the Fed Funds rate materially – and several new options: Will they expand “QE2” beyond $600 billion (Large Scale Asset Purchases, LSAP)? Will they stop short of the $600 billion in purchases? Will they continue to reinvest principal payments? Will the Fed sell assets in 2011?
The key is the Fed’s dual mandate on employment and inflation. From Chairman Ben Bernanke in November:
The Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 per cent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.
Today, most measures of underlying inflation are running somewhat below 2 per cent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.
[W]ith unemployment high and inflation very low, further support to the economy is needed. … The Fed is committed to both parts of its dual mandate …
Unless the unemployment rate falls substantially in 2011 – say below 8% – or inflation rises rapidly (well above 2%), I doubt the Fed will tighten policy in 2011 (except halting principal reinvestment).
Since I don’t think the unemployment rate will fall drastically (I’d like to be wrong!) or inflation rise sharply in 2011, I think selling assets or raising the Fed funds rate in 2011 is very unlikely.
The more likely debates will be:
• Will the Fed end LSAP (QE2) early? Currently the program is scheduled to purchase $600 billion in assets through June. It is very unlikely with the Fed’s current outlook (and mine) for inflation and unemployment that this program will end early.
• Will the Fed expand the LSAP beyond June (and beyond $600 billion)? This is a harder call. Based on Bernanke’s comments above – and the current projections – it would seem the Fed could do more. However it is very data dependent, and the Fed might hesitate in July and wait for more data.
• What is the likely order when the Fed does start to exit? I think the Fed will halt QE2 first (perhaps after June), and then stop the reinvestment of principal. But will they eventually sell assets or raise rates first? Based on some comments from NY Fed’s Brian Sack, I think they will raise the Fed funds rate before selling assets although it could go either way.
The exit strategy that is ultimately implemented will have to take into account the size and structure of the balance sheet at that time. However, in all potential circumstances the Federal Reserve should be able to tighten financial conditions to a sufficient degree when appropriate. The ability to pay interest on reserves, in combination with the ability to drain reserves as needed, will give us sufficient control of short-term interest rates. On that front, it is worth noting that both of the Fed’s reserve draining tools—the reverse repurchase program and the term deposit facility—are already operational, and their capacity to drain reserves will continue to expand. In addition, the Federal Reserve could always sell assets to reduce the size of its balance sheet if it desired.
To summarize my views:
- I don’t think the Fed will raise rates in 2011.
- Although data dependent, it is likely the Fed will halt QE2 in June and take a wait and see attitude.
- The only “exit” this year will be stopping the reinvestment of principal payments.
Also I’ve heard some people suggest the dual mandate might be changed to only tracking inflation. That is an easy prediction: Not. Gonna. Happen.
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