Tapering and the shift from QE toward forward guidance

Today’s commentary

Summary: The Federal Reserve meets today and tomorrow to decide on the next step on monetary policy. While most are fixated on tapering QE, in my view this meeting is crucially important because it not only will mark a regime shift away from quantitative easing toward forward guidance, it also will reveal the Fed’s playing hand through 2016. Likely, the Fed will continue to taper into 2014 and hike rates in 2015. Not only that, for the first time, the Fed will also tell us when it expects to hike rates even beyond the first rate hike. Below I have an in-depth review of how we got here and specifically what to expect going forward.

A brief history of recent US monetary policy

Before we get into exactly what’s going to happen today and tomorrow, let’s start from square one with why we got here with a brief look at the Fed’s overarching monetary policy paradigms. After the Volcker monetarist experiment in the late 1970s failed to both control monetary aggregates and inflation, the Fed moved back to an interest rate paradigm. The goal was to control inflation by hiking interest rates to intolerable levels. While the economy collapsed under this strain, inflation also collapsed and most attributed the collapse to interest-rate targeting. Thus began the 25-year regime of interest rate targeting at the Fed.

After the re-assumption of the interest rate paradigm, the Fed used the discount rate and the federal funds policy rates to transmit monetary policy to the US economy, both to cool the economy when it overheated and to ease monetary policy when the economy hit the skids. This has generally been the Fed’s main policy tool.

However, when the financial crisis hit in 2008, the Fed was forced to lower rates so drastically to introduce policy accommodation that it began to consider other mechanisms to transmit monetary policy. Because the crisis had many overtones similar to the deflation and crisis of the Great Depression in America and the Japanese lost decade, Ben Bernanke, as Fed chair and student of the Great Depression, felt well-placed to introduce new policy tools. In 2002, he gave a famous speech at the National Economists Club, now dubbed “The Helicopter Speech” which gave full voice to his ideas on how to prevent deflation in crisis. And since 2008, Bernanke has been implementing those ideas in textbook fashion.

The Fed’s view of its crisis monetary policy

As Bernanke has since told us, the Fed has two main unconventional monetary policy tools to use when it can’t use interest rate policy – quantitative easing and forward guidance. Let me quote from a speech he gave in October 2012 at length because it is quite specific about the Fed’s thinking on monetary policy and unconventional policy. In October 2012 after QE3 began, he said the following:

“As the nation’s central bank, the Federal Reserve is charged with promoting a healthy economy–broadly speaking, an economy with low unemployment, low and stable inflation, and a financial system that meets the economy’s needs for credit and other services and that is not itself a source of instability. We pursue these goals through a variety of means…

But today I want to focus on a role that is particularly identified with the Federal Reserve–the making of monetary policy. The goals of monetary policy–maximum employment and price stability–are given to us by the Congress. These goals mean, basically, that we would like to see as many Americans as possible who want jobs to have jobs, and that we aim to keep the rate of increase in consumer prices low and stable.

In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices. Generally, if economic weakness is the primary concern, the Fed acts to reduce interest rates, which supports the economy by inducing businesses to invest more in new capital goods and by leading households to spend more on houses, autos, and other goods and services. Likewise, if the economy is overheating, the Fed can raise interest rates to help cool total demand and constrain inflationary pressures.

Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008–a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, “What do we do now?”

To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero. We reasoned that, as with traditional monetary policy, bringing down longer-term rates should support economic growth and employment by lowering the cost of borrowing to buy homes and cars or to finance capital investments. Since 2008, we’ve used two types of less-traditional monetary policy tools to bring down longer-term rates.

The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market–principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed’s purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities. That downward pressure transmits to a wide range of interest rates that individuals and businesses pay. For example, when the Fed first announced purchases of mortgage-backed securities in late 2008, 30-year mortgage interest rates averaged a little above 6percent; today they average about 3-1/2 percent. Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.

The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed’s basic strategy for strengthening the economy–reducing interest rates and easing financial conditions more generally–is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.”

So that’s exactly how the Fed sees the policies it has been implementing.

My view of the Fed’s crisis monetary policy

Let me say this though. QE1 was a legitimate lender of last resort operation in which the Federal Reserve stepped in as an intermediary when banks refused to lend to one another. The goal was to re-animate the credit markets in order to prevent the daisy chain of bank failures and economic collapse the US experienced during the Great Depression. The Fed was successful in this effort and ended QE1 when it felt it had done the job.

However, when the US economy threatened to roll over yet again, the Fed embarked on QE2 from November 2010 with the explicit goal of boosting the economy, not unsticking failed credit markets. And this is what Bernanke is giving voice to in the October 2012 speech. But this policy was a big regime shift that caused outrage and made the Fed a lightning rod of political criticism. 

When the US economy rolled over yet again in 2011, the Fed therefore decided to support the economy again. But the Fed moved away from QE and introduced another tool, what I then called rate easing but what has now become known as forward guidance, in order to deflect criticism about QE. Finally, last year, yet again the US economy wilted and the Fed came on board with its fourth easing round and third round of QE, buying both mortgage-backed securities and treasuries in the process.

As I have covered this ground extensively in the past, I have only briefly mentioned the regime shifts we have gone through since 2008. For the most complete analysis, see my post “How Quantitative Easing Really Works” from March 2011, “What are the differences between QE1, QE2 and QE3?” that I wrote in June 2011 in anticipation of forward guidance as well as my post “The Fed has already begun its third easing campaign” after forward guidance first began in August 2011. Also see Steve Keen’s “How QE works and what this means for asset prices and credit“.

I would sum it up this way: the Fed intervened as lender of last resort during QE1 and prevented the deflationary spiral that would have resulted from the crash in interbank lending and concomitant wave of bank failures. When the economy turned down again in 2010, 2011 and 2012, the Fed turned to this tool and to another tool, forward guidance, to support economic growth. And that’s where we are now.

Forward Guidance: Where we are now headed

The Fed is about to make a drastic shift in policy. Tapering marks a shift away from QE and the first move to  normalize policy. The QE paradigm has played out and I believe forward guidance is going to be the Fed’s regime policy before it resumes conventional interest rate monetary focus in 2015 and 2016. After the break, for members I am going to outline exactly how and when the Fed is going to move toward policy normalization.

Let me say at the outset here that a lot of what I am going to be writing comes via ideas I garnered from Morgan Stanley’s Chief Economist Vincent Reinhart and comments he made at a Euromoney conference on inflation-linked products that I attended last week as I agree with his characterization of the situation.

Reinhart said that despite the recent market turmoil as the Fed signalled the move to taper QE, the Fed believes that forward guidance is the more effective unconventional monetary tool at this time and that it is going to move away from QE toward forward guidance. I agree. The reasons here are manifold. But let me give you two main reasons. The first is political. QE, by expanding the Fed’s balance sheet and making overt moves into the private sector’s asset markets, is the more controversial policy. In terms of cost-benefit analysis, the Fed went with quantitative easing because it was deeply concerned that the US economy was in serious jeopardy of a deflationary spiral. All indications are that the Fed has become more concerned about frothy asset markets and less concerned about deflation despite the fact that both CPI and PCE-inflation measures are below target. And so, it stands to reason that they will move away from QE for that reason.

Second, the Fed, believing that the US economy is off life support, wants to normalize policy. To do so, it needs to hike rates. And to hike rates, it needs to be in a position to do so. Getting back to conventional monetary policy means unwinding unconventional policy and that necessarily means forward guidance will take precedence. The Fed must unwind its QE program and it therefore needs a way to signal to markets its stance on interest rates as it makes this shift. Forward guidance is the vehicle.

Now, Reinhart only recently left the Fed. So I believe he knows what is going on at the Fed better than most. Reinhart says the Fed wants to become more scientific about what remains of unconventional monetary policy. And so it is in the process of setting up parameters to do this. Tomorrow’s FOMC statement will be crucial in this effort. Now, Reinhart mentioned that the Fed’s view is that forward guidance constrains the FOMC in the future because it sets out specifics that the Fed must live up to. Moreover, I would add that the Fed wants to maintain credibility. And therefore for forward guidance to be effective over the medium term it has to be adhered to in some discernible and consistent fashion.

The Fed’s Framework on monetary policy

Here’s a brief outline of how the Fed thinks about policy now:

First, there are the three components of long-term interest rates, the short-rate, expected future short rates and a term risk premium.

• The Fed controls the current short-rate through open market operations
• The Fed influences expected future short rates through communication of its forward guidance
• The Fed has less influence over the uncertainty surrounding the path of short-term rates

Then there is forward guidance. As the Fed moves toward the interest rate policy tool it has become more specific about forward guidance:

• The Fed started by saying it would keep rates low for a considerable period
• Then the Fed made general and unconditional macro-based threshold commitments
• Then the Fed began making specific and targeted macro-based thresholds and triggers on unemployment and inflation
• I believe what is coming next is also more on a lower bound inflation threshold in order to be able to revert back into the QE paradigm if the economy undershoots

While the Fed is still in the QE paradigm, it will continue to show us the following:

• The Fed will send signals to the market on its level of accommodation by adding to or reducing duration from the market.

As an aside, there has been a discussion about whether QE is a stock or flow variable, meaning whether the stock of assets on the Fed’s balance sheet matters or whether the flow of assets the Fed buys matters. Reinhart believes that QE is a stock approach to signalling accommodation meaning that QE is not just about how many assets the Fed buys but also how much it has on its balance sheet as well. I don’t have a view on this yet. But it may become an important part of the Fed’s framework to think about as it tapers and leaves the QE regime.

What the Fed will do

So, given the forgoing, where are we headed specifically?

Vincent Reinhart outlined why he thinks the economy will accelerate from here, something I am not onboard with. But I think this is also what the Fed believes and so here it is. There are four reasons:

• We are past the maximum level of fiscal consolidation. From here on out Reinhart believes the level of consolidation will be lower.
• The drag of the crisis – housing, deleveraging – is waning
• House price wealth is bolstering balance sheets and supporting consumption
• Business will begin greater capital expenditure given the first three points

In Reinhart’s view this translates into 200,000 jobs per month, meaning we will hit the Evans Rule of a 6.5% unemployment threshold by early 2015. As a result, the Fed will begin raising rates sometime in 2015.

In tomorrow’s FOMC statement we will also see ALL of the Fed Presidents’ forecasts for the inflation and growth through 2016 for the first time. So we will know not only when the Fed starts raining rates but also the path of the rate hikes beyond that through 2016.

I also believe the Fed will taper QE purchases. Reinhart says he expects $10-15 billion of tapering and that sounds reasonable to me. I would be surprised if they taper more than $20 billion. Moreover, I fully expect the tapering to occur all via Treasuries first because the Fed is concerned that the large recent uptick in mortgage rates could cool the economy too much and cause their timetable to slip.

That’s it for now. I have a bit more to add later today or tomorrow.