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I am cautiously enthusiastic about the Fed’s recent policy evolution.Enthusiastic, because it represents a significant move toward better management of expectations, which is a critical policy tool in a world where the policy interest rate can’t be reduced any lower.
But cautiously so because, frankly, I’m not sure it will work. Not, however, for the reason my colleague suggests:
A much bigger risk is that for all the theoretical appeal of the Evans rule, it is not at all clear the Fed’s tools can deliver the lower unemployment it wants. If the public shares that scepticism, the expectations effect won’t work.
The Fed did say it would step up QE to $85 billion a month; Operation Twist, under which $45 billion of long-term Treasurys were bought in exchange for short-term paper each month, will be replaced by $45 billion of Treasury purchases, financed by printing money.
But will those bond purchases do much good? The quick rally and reversal in equity markets is not encouraging. It may be, of course, that the new thresholds don’t change the path of tightening already discounted in the market.
I don’t think the Fed is powerless to boost the economy or shape market expectations. I think markets are flat partly because this sort of move was already somewhat priced in and partly because they’re reacting to what the Fed is doing with its left foot as well as to what its doing with its right foot.
What’s that, you say? Monetary policy is often analogised to driving. The Fed (or whichever central bank) is aiming to maintain a certain speed and using its policy tools—the pedals—to do it.
For some time now the Fed has been acknowledging the unacceptably high unemployment rate amid low and stable inflation and easing policy as a result. It has acted multiple times to expand its balance sheet and extend the duration of its holdings, and it has used guidance to convince markets that rates will be low for a long time, even after the recovery begins to pick up pace.
That all amounts to added pressure on the accelerator. And the Fed’s seeming hope has been that such pressure would allow the car to speed up and then maintain that higher speed without Fed help, coasting, as it were, thanks to the levelling out of the road (due to progress on deleveraging and so on; apologies for metaphor abuse).
But what the Fed has instead observed is that increased pressure on the accelerator leads to temporary bursts of speed which quickly peter out, leaving the underlying trajectory of recovery—its average speed—unchanged.
And this, in turn, has encouraged many of those watching the car’s progress to conclude that the engine simply isn’t strong enough to overcome headwinds along the road, or that the car could stand for someone to press the button releasing a nitrous oxide burst of fiscal stimulus (again, apologies).
My view, however, is that the problem seems to be the driver himself. Like a rather poorly trained motorist, the Fed has a foot on each pedal (for your sake, reader, the transmission is automatic in this metaphor). And while it moves the foot on the accelerator up and down, hoping to get the economy up to a nice coasting speed, it simultaneously has its left foot a good halfway down on the brake.
How do I figure? Well, consider the projections released this week:
The economy needs a short period of above-target inflation to get moving again, and many economics journalists have concluded that the Fed is acknowledging this and preparing to deliver it by adopting its new numerical thresholds. The new figures, recall, suggest that rates probably won’t rise until 1- to 2-year inflation expectations rise to at least 2.5%.
But while the Fed seems to be hinting that it may tolerate above-target inflation, it is by no means suggesting that anyone should expect above-target inflation. As the projections above make abundantly clear, the policy-making body charged with controlling inflation anticipates that it will be 2%, at most, through 2015.
That’s a giant, heavy-soled boot sitting on the brake pedal. The Fed is using one tool to try and convince the economy to raise its expectations for growth while clearly demonstrating with another that any such increase in expectations would be wholly unjustified. And that simply isn’t going to work. What it will get us is what we’ve had so far:
That’s the year-on-year change in employment and nominal GDP since the beginning of 2011. Both lines are remarkably flat. That flatness could be pure luck or the outcome of finely tuned fiscal policy, but I doubt it. Instead, it looks to me like the work of a monetary policy that’s carefully constraining growth on the downside and the upside.
I’m hopeful that the Fed’s recent policy shifts reflect an effort to prepare the ground for the moment, quickly approaching, when the left foot is lifted from the brake. But I’m worried that the Fed might not even be aware of what its left foot is doing and may be losing confidence in its right along with many of the rest of us.
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