The most newsy point from NY Fed president William Dudley’s speech today was his call for a change in exit strategy, urging the central bank to reinvest in its mortgage portfolio. But there was a lot more going on in the speech: Mr Dudley put a dovish spin on the Fed’s inflation target. He said bank regulation may be driving down neutral interest rates, and he put markets on notice that how they price bonds will decide how the Fed changes interest rates.
(1) Inflation is coming
Mr Dudley’s tone on inflation was different to the isn’t-it-worringly-low type of remarks that Fed officials have tended to make recently. Instead, he expects inflation to head upwards, and seemed to be testing arguments for why Fed policy should not react.
“With respect to the outlook for prices, I think that inflation will drift upwards over the next year, getting closer to the FOMC’s 2 percent objective for the personal consumption expenditure deflator . . . That said, I see little prospect of inflation climbing sharply over the next year or two. There still are considerable margins of excess capacity available in the economy—especially in the labor market—that should moderate price pressures.”
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When we look back on the FOMC meeting on June 19 2013, it will probably be seen as the moment when the Fed signalled that it was beginning the long and gradual exit from its programme of unconventional monetary easing. The reason for this was clear in the committee’s statement, which said that the downside risks to economic activity had diminished since last autumn, presumably because the US economy had navigated the fiscal tightening better than expected and the risks surrounding the euro had abated.
This was the smoking gun in the statement. With downside risks declining, the need for an emergency programme of monetary easing was no longer so compelling. The Fed has been the unequivocal friend of the markets for much of the time since 2009, and certainly ever since last September. That comfortable assumption no longer applies. Read more >>
The paper at this year’s US Monetary Policy Forum – where market economists get to present to central bankers – is called “Crunch Time: Fiscal Crisis and the Role of Monetary Policy“. It shows a new wrinkle on US fiscal problems: if there is any kind of debt sustainability crisis it could make the Fed’s exit from easy monetary policy a whole lot more painful.
This is the money chart. Black is the baseline for Fed profit and loss in the coming years. Red is what happens if a fiscal crunch pushes up long-term bond yields (and hence causes losses for the Fed on its portfolio). Read more >>
Today’s FOMC minutes suggest that the detailed record of meetings will still be interesting even after the Fed chairman has given a press conference and the best bit – the economic forecasts – have been released.
The minutes of the April meeting are notable for a detailed discussion of exit strategy. Much of this is familiar: it reaffirms the rough ordering of: (1) Stop reinvestments; (2) Change forward guidance; (3) Drain reserves; (4) Raise short-term rates; (5) Sell assets. Read more >>
I’ve been thinking about what Fed chairman Ben Bernanke said in his press conference about reinvestment of maturing assets from the Fed’s portfolio.
“At some point, presumably early in our exit process, we will – I suspect based on conversations we’ve been having around the FOMC table it’s very likely that an early step would be to stop reinvesting all or a part of the securities which are maturing. But take note that that step, although a relatively modest step, does constitute a policy tightening, because it would be lowering the size of our balance sheet and therefore would be expected to essentially tighten financial conditions.”
If it is the stock of Fed assets that matters, as the Fed believes, there is no doubt that this is literally correct. Reduce the size of the balance sheet and you tighten monetary policy.
But the direct tightening would be incredibly small. I think a much more pertinent reason for Mr Bernanke’s comments is to send a signal that short-term interest rates are going to stay low and discourage the market from pricing in an earlier tightening. Read more >>
There are some extremely interesting points in today’s FOMC minutes which provide more forward-looking policy signals than any others I can remember recently.
No taper of QE2
The signal here could not be more clear. The New York Fed “indicated that the greater depth and liquidity of the Treasury securities market suggested that it would not be necessary to taper purchases in this market”.
Fed officials are not persuaded that there is any monetary policy value in sending a signal through a taper so a request from the markets desk was the only remaining uncertainty on this point.
“In light of the Manager’s report, almost all meeting participants indicated that they saw no need to taper the pace of the Committee’s purchases of Treasury securities when its current program of asset purchases approaches its end.” In other words, it’s not going to happen. Read more >>
Some commentators have their knickers in a twist about the rise in the monetary base since February. The reason for it, of course, is that the Treasury has suspended its Supplementary Financing Programme in in order to buy time for Congress to raise the debt limit. The correlation between the SFP and bank reserves (and hence monetary base) is very clear.
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Atlanta Fed president Dennis Lockhart, speaking at the NABE policy conference today, provided some useful thinking about Fed exit strategy from its current easy monetary policy.
Judgments regarding when to change the direction of policy are difficult, and much of our thought and energy are devoted to getting it right. But by employing a forward-looking Taylor-rule framework, when to exit is not a particularly bewildering problem conceptually.
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As Ralph predicted, the ECB has extended its offer of unlimited funding at its three-month operations until July 12, rather than reverting to auctions. Funds would be lent at an indexed fixed rate, of as yet unknown value – derived from the rates at weekly ECB auctions.
Since the collapse of Lehman Brothers in September 2008, the ECB has met in full banks’ demands for liquidity. It is frustrated that some banks – perhaps as few as a dozen – remain “addicted” to this liquidity and unable to fund themselves normally.
So far, it has stopped providing unlimited six-month and one-year loans; a logical next step on Thursday would be to reintroduce auctions for three-month liquidity. But the ECB could delay this – in spite of its hawkish inflation instincts, there are reasons for a prudent non-standard measures “exit strategy”.
Delay is exactly what the ECB has done, by three months. Given Ralph’s predictive prowess, worth noting his suggestion that tempers as well as interest rates might rise in April: Read more >>
Janet Yellen prefaces her speech today by saying that “it is not my intention to provide new information about the outlook for the US economy or monetary policy” but it is extremely tempting to read two scenarios that she sets out (as illustrations of the effects of Fed communications) as primary policy options for the next couple of years.
Scenario 1 – Delayed tightening
“If financial market participants appeared to be expecting policy firming to begin somewhat sooner than policymakers considered desirable or appropriate under such circumstances, the language of the forward guidance could be adjusted to shift expectations toward the somewhat longer horizon over which the Committee expected the federal funds rate to remain extraordinarily low.”
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