US Monetary Policy Communication: Entering a Crucial Period
Historically, the credibility of the Fed ultimately hinged upon the implementation of policy measures aimed at achieving its dual mandate. The twin policy goals were bestowed on the Fed in 1978 when unanticipated inflation was wreaking havoc in financial markets and the real economy. Not surprisingly, in following years, the Fed’s credibility was judged in the context of whether policy measures produced lower inflationary expectations. We now live in different times, where the quality of communication via forward guidance vis-à-vis actual policy measures can determine the perceived credibility of a central bank. The Fed and the Bank of Japan have both flirted with damaging their reputations through mediocre communication with financial markets during 2013. US monetary policy is at a critical juncture with the arrival of a new Fed Chair, along with numerous changes of personnel on the Federal Open Market Committee (FOMC). Throughout 2013, the FOMC has struggled to convince markets that there are two independent pillars to US monetary policy: 1) asset purchases, and 2) short-term interest rate guidance. An early and urgent requirement in 2014 will be for the FOMC to convince markets that these two pillars will continue to remain separate.
Unhealthy Media Obsession with Tapering Continues
Since May, the media has been fixated with the pending arrival of tapering. There have been negative financial market consequences due to this obsession. Tapering has been incorrectly perceived as policy tightening, even though Chairman Bernanke went out of his way to explain that it simply represented a lower degree of policy accommodation. The other measures of policy stance, such as the level of short-term interest rates and excess reserves, were simply ignored by the media. The Fed Chairman did, however, contribute to the confusion by linking the end of asset purchases to the unemployment rate. This produced an undesired outcome: short-term interest rate expectations became unhinged between May and September, because markets believed the 6.5% unemployment rate policy threshold for short-term interest rates was no longer relevant. The unhinging of short-term interest rate expectations was a credibility blow to the Fed. It was a factor behind the seemingly shocking decision by the FOMC in September not to invoke tapering as a means of reaffirming forward guidance. Since September, however, short-term interest rate expectations have become realigned with forward guidance, indicating that markets are starting to understand the separation between asset purchases and short-term interest rate policy.
Composition of US Monetary Accommodation: Changes Ahead
The efficacy of asset purchases under the third tranche of quantitative easing was always going to be constantly debated on the FOMC. Chairman Bernanke made a point about communicating the regular reviewing of the size, pace and composition of asset purchases when the tranche was incepted a year ago. At the same time, greater policy weight was attached to reducing unemployment: “substantial” improvements in labour market conditions were required before tapering could even be considered. Judging from the minutes to the 29-30 October FOMC meeting, members are now viewing the costs of the current structure of asset purchases as being larger versus the benefits imparted to the real economy. The FOMC discussed potential scenarios where asset purchases would be wound down without unambiguous and substantial improvements in labour market conditions. Why would the Fed contemplate these alternatives when data dependency has been stressed for so long? Asset purchases were supposed to ease monetary conditions by reducing the term premium embedded in long-term bond yields. Chairman Bernanke recently admitted, however, that Fed economists were now less certain about the macroeconomic benefits from lower long-term interest rates attributable to a narrower term premium.
While lower long-term interest rates stimulate economic activity, recent research by Fed staff argues for more nuanced analysis. There are two main components to long-term interest rates: 1) the expected path of short-term interest rates, and 2) the term premium. Recently, a Fed staff research study estimated that a decline in long-term interest rates due to lower short-term interest rate expectations imparts twice the stimulus to overall economic activity compared to a similar decline solely attributable to the term premium. The policy implications are obvious: tapering should be accompanied by an extension of forward guidance to keep short-term interest rates low for a longer period.
The Term Premium and Asset Prices
One of the implications of the Fed’s research into the economic impact of falling long-term interest rates is that any change in monetary conditions will now be assessed in the context of its source, to either short-term interest rate expectations or the term premium. Given that short-term interest rates are believed to impart a greater impact on the real economy, it is now conceivable that the Fed will tolerate rising bond yields due to a higher term premium being demanded. Meanwhile, changes in the term premium are now being viewed as having more influence on risky asset prices, as opposed to the real economy.
Quantitative easing has had a direct impact on the term premium via the removal of duration risk from the open market. This has increasingly forced private investors to embrace alternative assets, such as corporate bonds, that are not perfect substitutes for mortgage backed or Treasury securities. It became increasingly evident that, with every new tranche of quantitative easing, it was the riskier components of the capital structure that benefitted the most from the Fed’s asset purchases. Small wonder why the Fed wishes to shift the onus of monetary stimulus back to short-term interest rates by keeping them low for a longer period than currently indicated in forward guidance.
Bracing for a Steeper Yield Curve
If we accept that asset purchases will end at some point, and that the Fed is willing to tolerate a higher term premium, then investors need to brace themselves for a steeper yield curve. This follows a five year period where Fed policy has deliberately aimed to flatten the term premium. The economic implications of this shift are most likely to be felt via changes in bank lending behaviour.
US banks have enjoyed the luxury of earning interest on reserves at the Fed since 2008. They currently sit on excess reserves of $2082bn. If we assume no change to short-term funding costs, higher long-term interest rates could potentially create the incentive for banks to engage in more lending. Why? Rising long-term interest rates result in capital losses on bond portfolios. It will force banks to search for an alternative source of net income within overall bank credit. A liquidation of securities held on the investment account could be offset by more lending at higher margins. Banks can exercise greater control on their lending margins, whereas the returns on bond portfolios have largely been dictated by the Fed in recent years. Hitherto, banks have yet to rush headlong into this shift in asset composition, but the impending arrival of a new look FOMC could spell a big change in opinion about accepting a steeper yield curve.
Policy and Personnel Changes on the FOMC
There are seven changes of personnel due on the FOMC during 2014. This is an unusually large number due to impending vacancies on the Board of Governors. President Obama will need to nominate three new appointees for the vacant posts. Meanwhile, there will be four changes of representation by regional Federal Reserve Banks. The Presidents of the Federal Reserve Banks of Dallas, Philadelphia, Minneapolis and Cleveland will become voting members on the FOMC. While the President of the Cleveland Fed has not yet been appointed, the Presidents of Dallas and Philadelphia are known for their more hawkish policy views. The President of the Minneapolis Fed has, in recent years, undergone conversion from a hawk to a dove. The sheer number of personnel changes on the FOMC in 2014, along with its new Chair, could result in elevated policy uncertainty, particularly the path of asset tapering.
The recent vote by the Senate to outlaw filibusters on Presidential nominations now makes it easier for President Obama to quickly fill the upcoming vacancies on the Board of Governors. There are some commentators conjecturing that the President will nominate policy doves to backstop the new Fed Chair, Janet Yellen. There are also rumours that Ms Yellen may assume her new post ahead of the 17-18 December FOMC meeting. This would be unusual, but the importance of the current Chairman’s views is becoming increasingly diluted. Markets are clearly fixated about how the Fed will operate under Ms Yellen’s leadership. Having to wait until February is seemingly adding to the sense of a policy vacuum.
Summary and Conclusions
The quality of central bank communication is now regarded as a key ingredient to its credibility. The Fed is at a critical juncture in policy conduct, given upcoming FOMC personnel changes: it needs to reaffirm the independence of the two core pillars of US monetary policy.
The media remains fixated with tapering, because it is incorrectly perceived as policy tightening. This misconception was partly due to poor communication by the Fed, which inadvertently unhinged short-term interest rate expectations between May and September. These have subsequently been realigned with forward guidance.
The Fed is deliberating a shift in the composition of monetary accommodation, with less emphasis on asset purchases. The impact of a lower term premium on economic activity has been questioned. Lower long-term interest rates due to short-term interest rate expectations are regarded as being more economically effective than reductions produced by the term premium.
The Fed is now analysing monetary conditions within the context of short-term interest rate expectations and the term premium. The impact of a lower term premium is being increasingly felt on risky asset prices. This accounts for the impending shift in Fed policy tactics to place greater emphasis on short-term interest rates by keeping them at current levels for a longer period.
After five years of policy aimed at keeping the yield curve flat, the rotation of Fed policy away from asset purchases will result in a steeper yield curve. This should force banks to free up lending at higher margins to offset portfolio losses on bond holdings.
There are a significant number of personnel changes on the FOMC in 2014. President Obama could use the Democratic Senate majority to fill the three outstanding posts on the Board of Governors with dovish nominees. Fed policy is seemingly in suspended animation until the arrival of a new FOMC.
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