Gavyn Davies plans to comment after the FOMC meeting finishes.
Ben Bernanke. Image by Getty.
As the Fed starts its special two-day FOMC meeting today, economists are uniformly expecting a further easing in monetary policy, and markets have priced this in. It would be surprising if the Fed did not deliver. The FOMC will be mindful of the fact that US core inflation has risen in the past few months, but the majority still seems confident that this will prove temporary. Recession risks, on the other hand, would quickly return if the Fed allowed financial conditions to tighten. That will be uppermost in their minds at this meeting.
It is useful to analyse the Fed’s options by asking what it is basically trying to achieve at present. The minutes of the August FOMC meeting made it clear that the majority of members are trying to ease monetary conditions by reducing long bond yields, and thereby flattening the yield curve. The thinking is fairly straightforward. Since they cannot reduce short rates below zero, the next most obvious way of easing policy is to reduce long rates towards zero as well. That was also the purpose which lay behind QE2; the rise in the monetary base which occurred as they increased the size of their balance sheet was an incidental side effect of the policy, not its primary purpose. And it has got them into a lot of political trouble.
That has forced them to think of other ways of flattening the yield curve without increasing the size of their balance sheet. Michael Feroli at JP Morgan suggests a useful way of looking at this. Long term bond yields are equal to the sum of future short rate expectations, plus a risk premium which represents the additional volatility and reinvestment risk in long dated assets. In order to flatten the curve, they need either to reduce the duration risk premium, or to convince markets that short rates will be lower for longer than currently expected. The markets call this “Operation Twist” and “Operation Shout”, respectively. At the August meeting, they discussed doing both, and actually took steps on the second, by promising to keep short rates at close to zero for the next two years.
This week, their focus is likely to be on how to reduce the risk premium further, or anyway hold it down to the levels it has recently reached. The markets fully expect them to do this by announcing “Operation Twist”, which involves selling short dated government debt and buying longer dated debt. The Fed holds about $500bn of sub 3-year debt. To judge from market commentary, they are expected to reduce these holdings by about $300bn-400bn, and to buy 7-30 year debt instead. The effect would be to increase the duration of the Fed’s bond portfolio by the equivalent of an outright purchase of roughly that amount of 10-year bonds, which is similar to what was done under QE2. But this time there would be no increase in the Fed’s balance sheet to inflame politicians.
The FOMC minutes also say that they will discuss further steps in “Operation Shout”. Charles Evans, Chicago Fed president, and a convinced dove, has suggested a concrete plan of action here. He says that the Fed could promise to keep short rates at zero until unemployment falls below 7.5 per cent, as long as inflation does not rise above 3 per cent. That would probably convince markets that short rates would remain at zero for even longer than 2 years, in which case long term bond yields might fall further. Ben Bernanke, Fed chairman, has reportedly asked Mr Evans to think further about such steps, along with (dovish) Janet Yellen and (hawkish) Charles Plosser.
However, there are severe problems with this type of forward commitment. The mere mention of 3 per cent inflation has already drawn sharp criticism from the likes of Paul Volcker, who believes that it would unhinge inflation expectations. And it is possible to think of reasons why the Fed might want to increase short rates, even if unemployment is above 7.5 per cent. For example, it could change its assessment of the structural unemployment rate. Or it might need to react to a dollar crisis, or a rise in inflation expectations, or an easing in fiscal policy. None of these developments seems very likely, but they cannot be ruled out over a period of several years ahead. And even if the Fed did try to pre-commit itself, markets would know that it could subsequently change its mind.
There certainly might be some extreme conditions under which further steps are taken in “Operation Shout”. For example, if the economy falls into a renewed recession, then explicit price inflation, or even price level, targets would come onto the agenda. But it seems unlikely that the Fed is ready to take these steps in current circumstances.
One last point about the likely effectiveness of the Fed’s actions. Consider the behaviour of the US and global yield curves over the past 18 months:
What is striking from the graph is that the curves did not flatten during QE2, and did not steepen after QE2 ended. In fact, the opposite occurred. The main factor driving the curve was the cyclical ups and downs of the global economy, not the specific actions of the Fed.
Of course, the bond markets are affected in general terms by their assessment of how they expect the Fed and other central banks to react to economic weakness, and they have already done that by flattening the curve very substantially as the global economy has weakened since early July. Although the FOMC can validate these expectations in the next couple of days, and will probably try to do so, it is hard to see how it can push them much further.
Related reading:
Money Supply – FT blog on central banks
FT Alphaville
