At last December’s FOMC meeting, Ben Bernanke announced the new Evans Rule (forward guidance thresholds) framework at least one meeting before most observers had expected it.
This year, market participants and Fed reporters have differing predictions for what the same meeting will bring, but they aren’t ruling much out. Even if markets are probabilistically favouring certain policy moves over others, it’s unlikely that any announcement in particular will qualify as a surprise.
Here’s a summary of potential changes, each of which could be announced in isolation or in combination with others (and do note that “none of the below” is also very possible):
In his recent speech on communications, Ben Bernanke said there was “greater uncertainty about the costs and efficacy of LSAPs” relative to its forward guidance on short rates. He further added that “to the extent that the use of LSAPs engenders additional costs and risks, one might expect the tradeoff between the efficacy and costs of this tool to become less favorable as the Federal Reserve’s balance sheet expands.”
Bernanke’s intent was ostensibly to convince the markets that a slowdown in the pace of asset purchases would not be a signal of an impending rate hike, or even of a necessarily less-accomodative stance for overall monetary policy. The emphasis was on the tradeoff between marginal costs and marginal benefits for the continued use of this specific tool, Quantitative Easing.
The latest readings for GDP growth and the unemployment rate were better than the Fed’s projections earlier in the year. Yet both are problematic as indicators of renewed economic vigour. The new estimate for third-quarter GDP growth was bolstered mainly by inventory accumulation, while there continues to be debate about the factors behind the decline in labour force participation these past few years.
Furthermore, the core and headline versions of the Fed’s preferred inflation measure have continued to run beneath its projections and (to an appalling extent) beneath its 2 per cent target:
Bernanke’s own comments have sometimes added to the difficulty of understanding the variables that govern the pace of QE. In June he floated a 7 per cent unemployment rate as an estimate for when the labour market will have improved “substantially”. In September he walked it back, and the rate is at 7 per cent already. His comments on the labour force participation rate and the importance of financial conditions have also been contradictory.
Adding to the potential complications of a taper is the imminent handover to Janet Yellen. It might make more sense for her to control the QE exit process from the start. And the markets are thinly traded in late December.
Finally, the New York Fed is watching the extent to which the Fed’s purchases are threatening the liquidity of Treasury and, in particular, MBS trading markets. The fiscal deficit is coming down and MBS balances have been shrinking; a reasonable case can thus be made that other than the all-important signaling channel, tapering really isn’t tightening.
(Note: I don’t entirely buy that argument, and I also don’t believe the Fed should begin tapering. But this post is meant to lay out the Fed’s options rather than build a case for or against them.)
A mixed picture, and nobody knows when the taper will begin. But even if it isn’t priced in for December, don’t be shocked if it happens.
As for what a taper would look like, it would probably start with a $5bn or $10bn reduction in the current $85bn pace of monthly purchases, though the split between MBS and Treasuries is every bit as unknown as the start date.
2) A change to the forward guidance thresholds:
This would most likely consist of lowering the unemployment rate threshold to adjust for the lack of clarity on the labour force participation rate (and suggesting that the decline in the unemployment rate has overstated labour market momentum). Along with the other ideas suggested here, it would be considered a dovish move to encourage a distinction between tapering and tightening. The idea received support in a much-discussed Fed staff paper last month.
One argument against is that it would cast doubt about the seriousness of the thresholds, a hesitation voice by some participants at the October FOMC meeting. The counterargument is that the reverse is true: it would actually enhance the Fed’s credibility by proving its willingness to adapt and be guided by honest readings of the data.
3) Adding an inflation floor to the existing thresholds:
Bernanke referred to this policy during the September presser as a “sensible modification or addition to the guidance”. The idea is to add a lower inflation floor, perhaps 1.75 per cent or higher, to the extant thresholds. The Fed would be agreeing not to begin raising rates until inflation had climbed above 1.75 per cent even if the unemployment rate threshold is crossed.
A recent Cleveland Fed note projected that a 1.75 per cent inflation floor would delay the first rate hike until the first quarter of 2016, a delay of four quarters relative to its current forecasts.
4) A small reduction in IOER
Because of the Fed’s new reverse repo facility, a reduction in the 0.25 per cent interest paid on reserves is more of a legitimate possibility than it was in the past, when Fed officials considered and then dismissed the idea. The reverse repo facility can help keep short rates positive and further compress secured and unsecured rates. (Earlier coverage here and here.)
But the facility is still in the testing phase, and it continues to seem unlikely that the Fed would risk the chance of either the overnight repo or the effective federal funds rate turning negative. Any cut would probably be a small one.
5) Other stuff
- Changes to the Summary of Economic Projections: expect a lower upper-bound for the central tendency of the unemployment rate, and also look for additional shifts in the numbers of participants who expect not to begin lifting rates until later.
- Additional clarity in the FOMC statement about the Fed’s perceived economic outlook
- New open-market operations to further guide the lower-for-longer signal: these were included in the latest FOMC minutes but didn’t seem to have much support.