Thoughts on the coming forward guidance policy shift
As I have been intimating for the last few months, the United States is in the midst of a regime change in monetary policy. We are moving from quantitative easing to forward guidance as the main unconventional policy tool to guide Federal Reserve monetary policy. This shift has been somewhat chaotic but it will happen soon. There are three options I see on the horizon. And these options have largely to due with the change in economic conditions in the US.
When Ben Bernanke mentioned the tapering of large scale asset purchases in May, I believe most Fed members felt this discussion was overdue. The US economy was expanding at a good clip and job growth had accelerated. Meanwhile signs of froth in asset markets were building, so much so that the Fed was worried about stoking bubbles that destabilized the economy. So the Fed believed that was the appropriate time to discuss exactly how it would normalize policy.
Unfortunately, the Fed’s actions communicated time inconsistency to the markets, making it seem like the policy choices of the Fed of 2012 were unappealing to the Fed of May 2013 and so the Fed was going to tighten. In retrospect, the discussion of tapering is a sign that the Fed wanted to normalize policy and therefore it was a de facto tightening even if the timetable was exactly the same. So it makes sense that rates backed up. And they backed up so much that the expectations of the market were well out of kilter with what the Fed actually wanted to do.
The problem for the Fed then was that not only had its conveyance of its own time inconsistency in decision making ruined its communications strategy, the backup in yields was having a measurable effect on mortgage rates, the housing market and the real economy. So the Fed had to re-think its strategy about normalizing policy and moving to forward guidance.
There are three options:
- The Fed could simply change its guidance. The Fed could simply tell the market that either the present 2.5% inflation or the 6.5% unemployment threshold is too hawkish and move the goalposts. This would be a full abdication by the Fed, an admission that its economic forecasts were wrong and that it was changing its guidance as a result. Tim Duy rightly points out that the Fed is reluctant to choose this response to the changed economic conditions.
- The Fed could add guidance that gives it more flexibility. For example, I have suggested the Fed could add in a lower inflation guidance threshold to complement its upper threshold. The purpose of doing so would be to counteract the unemployment threshold by making it less relevant if the inflation lower bound is triggered. Doing this would mean that the Fed would not violate any of its previous guidance. It would simply be enhancing previous guidance. According to the Wall Street Journal, this type of option has been mooted.
- The Fed could also add triggers to its thresholds. As I wrote last night, the letter by Janet Yellen to Elizabeth Warren indicates clearly that the Fed conceives of thresholds as guideposts or markers and not a boundary that will trigger an action. So the Fed could simply add the triggers outside of the thresholds, telling the market in effect that the threshold flips the Fed from accommodative to tightening bias and the trigger will result in a rate hike. I don’t particularly like this option because it seems a bit dodgy, as if the Fed gave guidance and then weasled out of the guidance. But it is a better option than the first one.
What is clear from recent Fed communications is that the Fed is still highly accommodative. The FOMC is now trying to find out how to best convey their accommodative stance in a way that does not force them to change guidance in the future. The conundrum is about giving as specific guidance as possible in order to get markets to move but avoiding being so specific that the guidance needs to be changed if the economy does not develop as expected.
In retrospect, the 6.5% unemployment threshold was too specific because we are approaching it quicker than the Fed anticipated without the economy lifting off in equal measure.