All Eyes On The Fed

All Eyes on the Fed

The Fed has both enemies and supporters in Congress. The behaviour of the US central bank will be under extra scrutiny by Congress during a Presidential election year. The ideal backdrop for the Fed would be to sit on the fence. The Fed does not, however, have that luxury: the mid-year economic slowdown in 2012 is the most serious since the end of the Great Recession. Under Chairman Bernanke, the Fed is publicly committed to keep the federal funds rate at current levels until late-2014.  What is unusual about the Fed’s conduct in 2012 are the enigmatic tones of its public communications. Markets have never felt 100% confident in their perceived understanding of Fed policy. Chairman Bernanke will have an excellent opportunity to set the record straight at today’s semi-annual testimony on monetary policy to the Senate Banking Committee.

Economic Forecasts Should Justify Future Policy Change

The Fed has conducted so-called forecast-based policy under Chairman Bernanke: the central tendency forecasts of the Fed set the underlying policy tone. Forecasts of slower growth and lower inflation will provide excellent ammunition for ordering an even easier policy stance. The Fed did exactly that at June’s Federal Open Market Committee (FOMC) meeting to justify an extension to Operation Twist. The political window for the Fed to engage in further aggressive asset purchases is, however, rapidly narrowing. There are three more FOMC meetings ahead of the Presidential election. The Fed will probably be loathed to announce a third tranche of quantitative easing after the 31 July/1 August meeting.

The looming fiscal cliff, notwithstanding continued elevated unemployment, provides the Fed with the perfect excuse to justify a softer economic outlook, particularly for 2013. It appears that rising uncertainty about the fiscal policy outlook is already causing the private sector to adopt a more cautious approach to both hiring and capital spending. There are two issues that will concern the Fed: 1) the reduced support to aggregate demand from the federal government sector, and 2) lower levels of “animal spirits” in the private sector. Taken together, the so-called multiplier-accelerator dynamic, so strong in the late-1990’s, will undergo significant degradation. This scenario needs to be avoided at all costs.

Has the Fed Contributed to the Slowdown?

The accusation that the Fed has been enigmatic in 2012 is based on the simple fact that communication policy was changed in January. The specific aim was to improve the signals about future policy conduct. This has simply not happened. The reason is that many FOMC members have not had strong convictions behind the economic forecasts underpinning the policy stance. With so many FOMC members lacking real conviction about the economic outlook, the apparent inability of Chairman Bernanke to dispel ambiguity about the future path of policy has not helped to reduce already very high levels of uncertainty in risky asset markets.

The Fed Chairman needs to display more decisive leadership in H2 in terms of conveying the goals of Fed policy, as well as exactly how the FOMC aims to achieve those goals. Until this happens, the Fed is likely to be vulnerable to accusations that it has contributed to the soft growth patch by failing to assure the private sector that it remains committed to supporting aggregate demand through further easing of monetary policy.

Until the private sector gets clear signals about the Fed’s commitment to ease policy further, if required, then risk aversion will remain high. US Treasury yields remain close to all-time lows. This is not solely attributable to Operation Twist being extended, but also due to genuinely strong demand from a variety of institutions (both domestic and foreign).

Understanding the Chairman’s Thinking on Policy Conduct

The Fed Chairman is an expert about the conduct of monetary policy in the Great Depression and after of the bursting of Japan’s bubble economy in 1989. His philosophy is simple: monetary policy needs to be decisive at times of crisis. He amply demonstrated this in the aftermath of the failure of Lehman Brothers. Accordingly, the Fed’s balance sheet rapidly rose under these circumstances. It was a necessary condition to stabilise the financial system. What are the current Chairman’s thoughts about further balance sheet expansion?

The political backdrop may be affecting the Chairman’s thinking: further purchases of Treasury securities by the Fed could invite Congressional accusations of political bias. Furthermore, there are rumours that Fed is worried about distortions being introduced, courtesy of its asset purchases, to the daily working of the US Treasury market, which is traded on an over-the-counter basis.

Markets were somewhat disappointed by the failure to engage in additional asset purchases at the June FOMC meeting. Fed Chairman Bernanke gave, however, the impression that the extension to Operation Twist represented a substantial easing of policy without having to resort to boosting the Fed’s balance sheet. It may mark a change of thinking about how future easing is implemented: easier policy may not always require balance sheet expansion.

I have argued that the next round of quantitative easing will involve purchases of both Treasuries and mortgage backed securities (MBS). One of the benefits of quantitative easing has been the reduction in interest rates charged to private borrowers, particularly mortgage rates. It has helped to significantly reduce debt servicing in the household sector. This development has not gone unnoticed by some FOMC members who are actively seeking to pursue further MBS purchases. Chairman Bernanke has not quite joined that group, but his position could potentially change.

Perhaps the biggest hurdle preventing the FOMC coming down in favour of further balance sheet expansion was core inflation. It started the year behaving in a very sticky manner. Under these circumstances, it would have been inappropriate to pursue further balance sheet expansion. This constraint no longer prevails. The Fed Chairman has always been a keen advocate of inflation targeting. The Fed established a 2% headline core personal consumption expenditure deflator target in January. The latest figure for May is +1.8%: the Fed’s chosen inflation measure is now below desired levels and may be a tad too low for comfort.

Summary and Conclusions

The Fed will not have the luxury of sitting on the fence during 2012. The mid-year slowdown in 2012 is the most serious since the end of the Great Recession. The Fed’s policy communication has been somewhat enigmatic this year, despite initiating measures in January aimed at circumventing ambiguity. The Fed Chairman needs to be more decisive in how policy intentions are conveyed, particularly given the looming fiscal cliff.

The Fed is vulnerable to criticism that ambiguity about its future policy path has contributed to the economic slowdown. Chairman Bernanke has an excellent chance to set the record straight at today’s semi-annual testimony on monetary policy.

The attitude of Chairman Bernanke towards balance sheet expansion may have shifted, as testified by his assertion that extending Operation Twist constituted significant monetary easing. Further policy easing by the Fed is likely, although balance sheet expansion need not necessarily be part of that easing. My hunch is that further asset purchases, skewed in favour of MBS, are likely.