It’s been a very interesting few weeks in the world of monetary policy and the economy.
Last month, Ben Bernanke spooked markets by making it very clear that it was “taper on” meaning that barring some surprise slowdown in the pace of job creation, purchases of bonds via Quantitative Easing would begin to get wound down.
Stocks dove. Interest rates jumped.
In a note that came out soon after Bernanke’s comments, Goldman’s Jan Hatzius suggested that the Fed could still stick the landing, and exit QE smoothly.
The key he said was making it very clear that tapering bond purchases had nothing to do with when the first interest rate hikes would come.
Hatzius explained how the Fed could do this. Basically Bernanke would need to make clear that there’s nothing to worry about if unemployment gets to 6.5%.
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 labour force participation rate over the past few years is a cyclical consequence of the labour demand shock during the crisis. This means that there is significantly more slack in the labour 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 labour 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 neighbourhood 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 sceptical 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.
Bernanke didn’t quite change the threshold for where the first rate hike could be considered, but at a Q&A yesterday he all-but moved to a more dovish stance on keeping interest rates low for a long time. He said for example that the current rate of unemployment was probably understanding the labour market weakness, due to the low participation rate. And he promised that after unemployment fell to 6.5%, rates would still stay low for quite some time.
It seems very likely that the Fed will basically do what Hatzius suggests, move down the Evan’s Rule threshold.
What Hatzius correctly identified in June is that that the inclination to reduce asset purchases was not about an inclination to tighten, but about concern over asset purchases themselves, and that the Fed would feel comfortable counteracting that tightening by loosening on the keeping interest rates low side.
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