Financial markets have seen violent swings lately, particularly in the fixed income market, as interest rates on Treasuries have surged in a manner that we haven’t seen since the end of the financial crisis.
Part of the reason for the rise in rates is the improving the economy, but a lot of it is believed to be the result of the Fed taking on a slightly more hawkish tone, and Bernanke indicating his inclination to “taper” the pace of bond purchases starting later this year.
But the ructions in financial markets, and the drop in inflation expectations, is a hint that perhaps the Fed is being premature, and that if things deteriorate again, and the Fed needs to press back down on the gas pedal, then it won’t have the credibility it needs, having been timid this time around. That’s Paul Krugman’s argument, who says that the Fed is making, potentially, a historic mistake.
So how can the Fed do better?
In a long note, Goldman chief economist Jan Hatzius talks about a A More Graceful Exit from QE.
Hatzius’ argument is that the taper is overblown as the big story.
Instead he points to this chart, of Fed futures, which indicate that market expectations for the timing of the first Fed interest rate hike have moved from May 2015 to December 2014.
In our view, the most compelling explanation for the reaction to Chairman Bernanke’s appearances is that market participants have shifted their monetary policy expectations more broadly than suggested by the small change in QE forecasts. A broader shock to expected monetary policy is consistent with the combination of higher TIPS yields lower breakeven inflation rates, and weaker equities over the past few weeks. More specifically, we believe that the bond market views QE tapering as a broader signal that the monetary policy exit is getting underway, and hikes in the funds rate will not be far behind. Exhibit 3 shows the change in the market’s pricing of short-term interest rates since Bernanke’s testimony to the Joint Economic Committee of Congress on May 22. The first hike in the funds rate has moved forward from May 2015 to December 2014, which is probably at least twice as much as expectations about the first tapering of QE.
So how can the Fed stick the landing?
It needs to make even more clear that it’s going to be a long time until the first Fed rate hike. One way it can do this is to reduce, even further (from 6.5%) the threshold at which it would consider raising rates.
If Fed officials want to take out insurance against a further tightening of financial conditions and the resulting downside risks to the growth and inflation outlook, they basically have two options. The first would be to delay the tapering of QE from “later this year” into 2014. This is certainly possible—Bernanke made it clear that the timeline now projected by the committee could change if the economic outlook changes. That said, we also agree with St. Louis Fed President Bullard that the mere fact that there is now an official timeline was a step away from state-contingent monetary policy which will presumably make policy less responsive to new information.
The Fed’s other option would be to alter the forward guidance for the federal funds rate. A return to calendar guidance is unlikely, but we were intrigued by Bernanke’s comment in the Q&A of the press conference that a reduction in the 6.5% threshold for the unemployment rate is “something that might happen.” As we discussed in early May, our own view is that a significant part of the drop in the labor force participation rate over the past few years is a cyclical consequence of the labor demand shock during the crisis. This means that there is significantly more slack in the labor market than suggested by the gap between the actual and structural unemployment rate alone—by our estimates about twice as much. Greater recognition of this fact would suggest that the FOMC should alter the threshold guidance for the funds rate, either by including the labor force participation rate or an employment/population ratio directly in the statement or—more likely—by adjusting the unemployment threshold downward.Separate from this, Vice Chair Yellen’s optimal control simulations suggest that the funds rate should not rise until the economy returns to the neighborhood of full employment—a criterion that would also point to a materially lower threshold than the current 6.5% .
A reduction in the unemployment threshold also looks attractive from a more tactical perspective. In our view, it could yield outsized benefits by dissuading market participants from assuming that a tapering of QE implies earlier hikes in the funds rate. At present, the markets seem skeptical of Bernanke’s repeated assertions that there has been no change in the committee’s view of the outlook for the funds rate. They seem to believe that Fed officials must have become at least somewhat more willing to consider earlier hikes if they are sufficiently comfortable with the economic outlook to preannounce QE tapering.
Bottom line: The taper could work smoothly if it clearly breaks any hint of a connection between tapering and stopping ultra-low rates.
…we think they would change their mind and take the FOMC at its word that it has not become more hawkish on short rates to a much greater degree in response to a move in the two policy tools in opposite directions—that is, a tapering of QE on the one hand and a reduction in the unemployment threshold on the other.
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