Since May, when market participants caught wind that the Federal Reserve was seriously contemplating tapering down its quantitative easing program sometime in the (perhaps near) future, the bond market has been a little more volatile than usual.
Over the summer, a lot of ideas were thrown around on Wall Street about how the Fed could pull this off without completely spooking the market. One of them was that it could lower the 6.5% unemployment rate threshold (introduced at its December 2012 meeting) for considering hiking short-term interest rates.
Goldman Sachs chief economist Jan Hatzius suggested it in early August.
“We still expect Fed officials to taper QE at the September 17-18 FOMC meeting, but to offset the impact on financial conditions by reinforcing the forward guidance for the funds rate,” said Hatzius in a note. “There are two broad possibilities for how this might happen. First, they could simply lower the 6.5% unemployment threshold.”
A new paper authored by economists at the New York Fed now has Hatzius predicting that the FOMC will do just that at its March FOMC meeting.
“It is hard to overstate the importance of two new Fed staff studies that will be presented at the IMF’s annual research conference on November 7-8,” says Hatzius. “Our baseline view is now that the FOMC will reduce its 6.5% threshold to 6% at the March 2014 FOMC meeting, alongside the first tapering of QE. A move as early as the December 2013 meeting is possible, and if so, this might also increase the probability of an earlier tapering of QE.”
The paper discusses an “optimal control” approach to monetary policy — one that suggests lower rates for longer as the Fed shifts its focus to fighting above-target unemployment, as long as unemployment remains further from its target than inflation, which currently does not appear to be a threat.
This just so happens to be an approach that incoming Fed chairman Janet Yellen has mentioned in recent speeches, and one that many expect may become the hallmark of the new Yellen Fed.
Connect the dots, and you have an interesting coincidence.
In a note to clients, however, BofA Merrill Lynch economist Ethan Harris asserts emphatically that this paper, contrary to popular opinion, is not some sort of policy signal meant to prime markets for the end of QE.
To begin with, Harris points out the biggest problem with optimal control: it makes sense in theory, but is very hard to implement in practice, as it it heavily reliant on models with hundreds of inputs. Yellen herself acknowledged this on the occasions that she spoke about it.
Harris does believe they will eventually lower the unemployment threshold, but they won’t do it when they taper down QE.
One popular view is that the Fed will change its forward guidance at the same meeting of the first tapering of asset purchases. This would minimize any shock to the market from tapering. While this is possible, we see four reasons for the Fed to separate these decisions.
First, they have already repeatedly explained that 6.5% is a very rough (and increasingly flawed) guidepost. Second, they don’t want to put even more focus on the unemployment guidepost by micromanaging it. Third, moving the two levers simultaneously seems a bit too clever for the straight shooting Bernanke bank. Recall that some forecasters also expected this double switch at the September meeting.
Finally, the Fed is in uncharted territory and with each move, it tries to learn about how its exit tools work. If they move both levers at the same time they undercut this learning process.
So, that’s his case for why lowering the unemployment threshold and tapering QE won’t happen at the same time.
But he doesn’t stop there — he is really emphatic that the paper is not a policy signal:
One final point: the recent discussion of the English paper holds lessons for how the Fed communicates. While the paper adds to the case for extending forward guidance, it should not be viewed as a “signal” of Fed policy. Under Greenspan, Fed watching was like a game of “Where’s Waldo?” with coded signals buried deep in speeches. Under Bernanke, Waldo has a large bullseye on his back: any important message from the Fed is in the directive, the press conference, the minutes, and the quarterly FOMC forecasts.
A research paper, even authored by senior Fed economists, is not the way the Fed is going to signal a major policy change. Bernanke and/or Yellen did not pop into English’s office and say: “Bill, could you and your colleagues do this 70 page paper that will signal to the rest of the FOMC and the general public a possible shift in policy guidance? No rush, we are not making policy changes at the September FOMC meeting, but we do need it done before the December FOMC meeting. I’ve called up the IMF to make sure their annual conference is timed right for you to signal a policy change.” The paper is a small window into the evolving policy discussion at the Fed.
While the Fed may eventually head in this direction, it’s probably not imminent. Click here to read more about “optimal control” and how it works »