Lockhart speech signals coming policy shift at the Fed

Earlier today, I indicated that comments yesterday by Fed President Dennis Lockhart clearly indicated that the Fed was poised to shift away from quantitative easing and toward forward guidance to guide future Fed monetary policy. But Lockhart gave a speech today which further signalled this policy shift. Neither time did Lockhart explain why this shift has occurred, leaving us to speculate on what is going on at the Fed.

Tim Duy spotted the key language in Lockhart’s speech today and rightly raised the question as to why the shift is taking place.

Here’s what Lockhart said:

Monetary policy is highly accommodative—as central bankers say. The FOMC is currently using two tools to maintain the desired degree of monetary accommodation—the policy interest rate and bond purchases. Importantly, the FOMC has stated that it intends to keep the short-term policy rate low at least until the unemployment rate falls below 6 1/2 percent. This “forward guidance” is meant to convey a sense of how long short-term interest rates will stay near current levels.

There is some confusion about how the Fed’s forward guidance and asset purchase program relate to each other. I will give you my view.

In the toolkit the FOMC has at its disposal, there is a sense in which asset purchases and low policy rates are complementary. Asset purchases and forward guidance on interest rates are complements in the sense that they are both designed to put downward pressure on longer-term interest rates. Asset purchases obviously exert downward pressure through the act of buying in specific maturity sectors of the Treasury and mortgage-backed securities market. Forward guidance on the short-term policy rate (the fed funds rate) influences market beliefs about the path of policy, and that too influences longer rates. Lower long-term rates encourage spending on business investment and consumer activity in interest-rate-sensitive sectors like autos and housing.

But there is also a sense in which these tools are substitutes. By substitutes I mean that guidance pointing to a sustained low policy rate and asset purchases are discrete tools that can be deployed independently or in varying combinations. They can be thought of as a particular policy tool mix chosen to fit the circumstances at this particular phase of the recovery. In my view, the use of these two tools has been effective in combination over the last many months. Both have provided stimulus. I think of asset purchases as supplemental stimulus on top of low short-term interest rates—current and prospective.

Going forward, it may be appropriate to adjust the policy tool mix. That will depend on circumstances and the economic diagnosis of the moment.

Now, the way I read Lockhart’s statement here is that he is endorsing the view that QE and forward guidance are substitutes when he says “there is also a sense in which these tools are substitutes. By substitutes I mean that guidance pointing to a sustained low policy rate and asset purchases are discrete tools that can be deployed independently or in varying combinations”. Yes, he goes on to say that they can be mixed and matched to obtain different policy mixes. But the overall message I get here is that Lockhart believes that forward guidance can substitute for QE, meaning that greater emphasis on forward guidance means less emphasis on QE.

I don’t want to read too much into Lockhart’s statement. But, in conjunction with other noises coming from the Fed, his speech does suggest that a policy shift is coming – especially when he ends the thought process by saying, “[g]oing forward, it may be appropriate to adjust the policy tool mix.”

I have written a lot about why I believe the Fed is shifting its policy mix but no one at the Fed has come right out and said why. Yes, it seems that forward guidance has come into favour but why? Is it because it is less political? Is it because it is less noticeable because no assets are purchased? Is it because it makes the move to policy normalization easier? I think so. I say yes to all of these questions. But I don’t have any special insight here. This is pure guess work. And in that sense, Tim is right. The Fed is not being very transparent. Let’s hope that they can open up more and tell us why they have acted once the expected shift has occurred.

Let me end this by quoting Lockhart in how he ends his speech with the emphasis exactly as in the original text:

I expect things to pick up in 2014, but it’s possible the economy will stay on its current track and we’ll see no acceleration. The right monetary policy for these circumstances is continued strong stimulus. That is not to say, however, that the mix of policy tools needs to or will stay the same.