The Fed announced today that the US economic situation is far from satisfactory, but that there is nothing much that it can (or will) do about it. Real GDP growth is, by its own admission, lower than the FOMC expected in April, and unemployment has been higher than anticipated. However, its concerns about inflation have risen and, significantly, it has dropped the previous assertion that “measures of underlying inflation are still subdued”. Chairman Bernanke believes that part of the recent slowdown is temporary, but admits that he is not fully confident that he understands the underlying causes. The FOMC is becalmed, and perhaps slightly bemused.
With the economy weaker than expected, but inflation having risen in a worrying manner, the FOMC has clearly decided that its previous policy settings require no immediate change. In part, this is because it believes (probably correctly) that some of the worsening in the growth/inflation trade-off is temporary and will prove self-correcting.
The supply chain disruptions from Japan are already dissipating, and the FOMC believes that the adverse effects of higher commodity prices will not prove long lasting. As before, it is content to permit the consequent rise in inflation to pass through the economy unimpeded by monetary policy tightening, as long as inflation expectations do not rise. And it remains as confident as ever that “longer term inflation expectations have remained stable”.
At present, the Taylor Rule supports the thinking that the Fed policy setting is in the right ball park. If we take one commonly used version of the rule – which is outlined in the note at the bottom of this blog - and enter today’s FOMC forecasts for unemployment and core inflation up to the end of 2012, we discover that the implied level of the Fed funds rate today would be almost exactly zero, no different from the Fed’s current rate. At the time of the last FOMC meeting in April, the equivalent calculation also suggested that the appropriate Fed funds rate was almost exactly zero. Hence, the offsetting changes in inflation and unemployment expectations have cancelled each other out, leaving the Fed sitting on its hands.
This is not untypical in a period following an adverse commodity shock. From the point of view of the markets, and indeed of the electorate, the performance of the economy has deteriorated on all fronts but the central bank has chosen to do nothing. As Mr Bernanke said recently, “monetary policy is not a panacea”. Or, in the words of a previous blog: “sorry folks, we are out of ammo”.
In the subsequent press conference, the Chairman was pressed on the FOMC’s exit strategy from unconventional monetary easing. On this, he emphasised very clearly that the Committee is intending to hold short rates at zero for two to three meetings, and very possibly longer. That is a stronger commitment than last time, which sounds dovish.
However, on the exit from QE, the Chairman refused to give any commitment whatsoever to a date at which policy might start to be tightened, even though he also said that it may make sense to do so. This suggests that he may be a prisoner of the Committee on this front, because some members may want to reverse QE2 on a fairly early timescale. This aspect of his evidence was more hawkish than I expected.
Furthermore, the Chairman was at pains to explain the differences between the current situation and the one last August, when he favoured more QE. Then, deflation risks were rising, and the Fed was missing both parts of its employment/inflation mandate on the low side. That is no longer true. There is no imminent deflation risk and, therefore, no case for further unconventional action.
Where does this leave the Fed? On its economic forecasts, zero is the “correct” level for short rates, according to the Taylor Rule, and they are staying right there. The Committee thinks, without much confidence, that some of the recent slowdown is temporary, so any thought of QE3 is right off the agenda for now. In fact, they are not committed even to leaving QE2 in place for very long. So we may see an attempt to shrink the balance sheet, while keeping short rates fixed at zero.
One last thought. The major central banks are moving in different directions at present. The Bank of England today hinted that it may do more QE. The Fed hinted that it may do less, while leaving rates at zero. And the ECB is still determined to raise rates. Interesting times!
Note: The version of the Taylor Rule used above is the one quoted by Sven Jari Stehn of Goldman Sachs in economics research published last Friday. This states that the Fed funds rate equals -0.4+2.1*expected core inflation-1.6*excess unemployment plus 100bp for the effect of QE.
