The Federal Reserve surprised observers last Wednesday by revolutionizing its strategy for communicating with the public on its monetary policy outlook through the introduction of the “Evans Rule.”
By adopting the Evans Rule, the Fed has now laid out thresholds that must be met before the central bank will consider raising interest rates, which have been held near zero since the financial crisis several years ago.
Whereas before, the Fed stated that rates would be held at zero at least until mid-2015, the language has been tweaked to suggest that rates will now stay low as long as unemployment is above 6.5 per cent and inflation is below 2.5 per cent.
The change has been hailed by critics of the Fed – those who charge that the central bank has not done enough to stimulate the economy – as a crucial step toward tapping its full stimulative potential by more forcefully shaping market expectations.
UBS economists Drew Matus and Sam Coffin do not share such a positive view of Wednesday’s meeting as everyone else, however.
In fact, Matus and Coffin suggest that contrary to popular belief, the Fed’s latest decision actually makes things more dangerous for markets and the economy.
In a note, the UBS economists warn clients, “Given that policy is now tied to the perceptions of a small group of individuals who all adhere to the same orthodoxy, this implies that monetary policy will continue to operate as a poor substitute for responsible fiscal policy and that the possibility of policy errors from such ‘groupthink’ remains a key risk for the foreseeable future.”
Matus and Coffin take issue with two facets of the Fed’s line of reasoning that were revealed at last week’s FOMC meeting.
The first problem concerns how the Fed views unemployment. The central bank views unemployment as cyclical – meaning the unemployment rate reflects the natural progression of the business cycle and should fall as the economic recovery picks up steam.
The UBS economists take the opposite view – namely, that unemployment is structural, and the natural rate of unemployment (abbreviated NAIRU) is now higher post-crisis than it was before, making a return to the 6.5 per cent unemployment rate identified by the Fed as entirely unlikely.
The chart below illustrates the UBS side of the argument with regard to structural unemployment:
The next chart shows the stark difference between the Fed estimate and the UBS estimate for the natural rate of unemployment:
What these charts suggest to the UBS economists is that if the Fed really stops at nothing until the unemployment rate falls below 6.5 per cent, which is below the investment bank’s estimate for the natural rate of unemployment, inflation could take the Fed by surprise as they ease aggressively.
If – contrary to the Fed’s forecasts – inflation were to pick up, it could complicate the central bank’s exit strategy, which still looms as the biggest uncertainty for market participants with regard to monetary policy.
However, the specific unemployment rate the Fed chose as a threshold for forward rate guidance wasn’t the only thing that confounded Matus and Coffin last week.
According to the UBS economists, the bigger reveal was what the Fed had to say about its widely-expected decision to replace Operation Twist with “QE4.”
The Fed’s fourth round of quantitative easing features $45 billion per month in purchases of long-dated U.S. Treasury bonds. Operation Twist did the same thing, except under that program, the central bank was also selling $45 billion per month in short-term Treasury notes to “sterilize” the effect of the purchases on the overall size of the Fed’s balance sheet.
Because the Fed has run out of short-term notes to sell, purchases under QE4 will be unsterilized, and the size of the central bank’s balance sheet will once again expand:
The point here is to highlight a shift in the Fed’s thinking. In last week’s press conference, Fed Chairman Ben Bernanke said:
What’s important is the fact that we’re acquiring Treasury securities and [mortgage-backed securities], taking those out of the market, you know, forcing investors into other closely related assets. And that’s where the stimulus comes from, not so much in the size of the balance sheet per se. So in my judgment, the amount of stimulus is more or less the same; it’s just being continued.
That puts Bernanke and the Fed squarely on the “flow” side of the “stock versus flow” debate. In other words, it’s the size of the current flow of purchases that determines the efficacy of the stimulus, not the overall size of the central bank’s balance sheet, or the stock of debt that the Fed accumulates.
However, QE4 will now actively expand the overall size of the Fed’s balance sheet, as shown above. Given that, Matus and Coffin wonder why the Fed decided to keep up the pace of $85 billion in total purchases of Treasuries and mortgage-backed securities per month, when the “flow” view of monetary stimulus dictates that much less is necessary to keep apace of the market.
The UBS economists write, “Assuming debt market growth is stable in 2013, the Fed could hold steady the percentage of the overall debt portfolio held on its balance sheet by purchasing just over $5 billion of assets per month versus the $85 billion it has announced.”
Matus and Coffin conclude that a dangerous dynamic may be brewing inside the Fed:
In short, consistency is lacking and the FOMC is increasingly tone deaf. This may be because, within the Federal Reserve System, the hawks are primarily “freshwater” economists who are concerned about the ever expanding balance sheet. In contrast, most of the rest of the FOMC are either non-economists (the majority of the Board of Governors) or “saltwater” economists. These economists dominate not just the Fed, but a number of central banks around the world.
As such, critiques are limited and critics outside the Fed often dismissed out of hand. Given that policy is now tied to the perceptions of a small group of individuals who all adhere to the same orthodoxy, this implies that monetary policy will continue to operate as a poor substitute for responsible fiscal policy and that the possibility of policy errors from such “groupthink” remains a key risk for the foreseeable future.
Meanwhile, with Richmond Fed President Jeffrey Lacker, the lone dissenter in several of the Fed’s most recent policy decisions in 2012, set to become a non-voting member on the Committee in 2013, that groupthink may grow even stronger.