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.”
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.
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.
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.”
This chart from Merrill Lynch via Alphaville (which shows how the market has made repeated false starts on when the Fed will raise rates) sent me off to CME Fedwatch to see when markets expect the first rise in Fed Funds.
The answer is that fed fund futures give a 22% chance of a rate hike by August, 41% by September, 54% by November, and 67% by December. I can only disagree: given what I understand of the FOMC’s reaction function, I think these probabilities only fit a scenario in which a large part of the FOMC has got its inflation forecast wrong and, by the autumn, been forced to change it. Read more
Ready for some true Fed balance sheet wonkery? Sit back and enjoy…
The US Treasury has announced today that it will suspend the Supplementary Financing Program (currently $200bn) that it runs to help the Fed. Here is the Treasury statement:
“Beginning on February 3, 2011, the balance in the Treasury’s Supplementary Financing Account will gradually decrease to $5 billion, as outstanding Supplementary Financing Program bills mature and are not rolled over. This action is being taken to preserve flexibility in the conduct of debt management policy.”
The point of all this is to give the Treasury more space to borrow as it waits for Congress to raise the debt ceiling – but it has consequences for the Fed. Read more
Today’s UK GDP shocker once again raises the question of whether the rapid, pre-announced tightening of fiscal policy underway in Britain is wise. But at least one new academic paper suggests that chancellor George Osborne has it right.
Ignazio Angeloni and colleagues at the Kiel Institute for the World Economy run fairly comprehensive simulations on exit strategies from crisis fiscal and monetary policies and conclude: Read more
The European Central Bank governing council goes into “purdah” on Thursday ahead of next week’s interest rate setting meeting. So Yves Mersch, Luxembourg’s central bank governor, has seized a last chance to sway the debate.
Action to stabilise Ireland’s banks “will allow us to continue on our gradual and prudent exit strategy,” he told CNBC on Wednesday. “I would not take issue with the expectations that are presently in the market.”
That suggested at least Mr Mersch favoured another step to restrict the liquidity the ECB is pumping into the eurozone financial system. Read more
The Bank of England today took three baby steps towards normality in its liquidity operations. None of these is significant in size, but together they show that Britain is, like the eurozone, seeking an exit from some of the unorthodox monetary policy.
In a notice today, the Bank said it was:
- giving 12 months notice of withdrawal for the Commercial Paper Facility, under which it bought short-term corporate paper. Today, it holds none, and this notice signals its intent to exit this market permanently
- withdrawing the Credit Guarantee Scheme Bond Secondary Market Scheme, which gave it the option to buy bank bonds backed by the government’s credit guarantee scheme. It has made no purchases and now will make none
- signalling its intent to sell more corporate bonds under the Corporate Bond Secondary Market Scheme. It will keep the scheme going but the decision comes as the Bank says the market has significantly improved.
Axel Weber has urged the ECB to consider exiting its support measures, saying the risks of waiting were greater than the risks of doing nothing. At a speech in New York on Tuesday, AFP reports the Bundesbank president saying: “It is necessary, from a monetary policy point of view, not to postpone the exit from non-standard measures for too long. There are risks both in exiting too early and in exiting too late. I believe the latter are greater than the former.”
Professor Weber, who is in the running to become ECB president next year, also repeated his view that the central bank’s bond buying program should come to an end, saying: “These securities purchases should now be phased out permanently as part of our non-standard policy measures.” The statements are on message for the ECB governing council member, who opposed the bond buying programme, and recently dismissed its role as “minor”. ECB bond purchases fell to near-zero levels last week, having shot up the week before. Read more
Just a few months ago, Jean-Claude Trichet, the European Central Bank’s president, would have felt some trepidation about spending a weekend with US counterparts. Back then, Europe’s debt crisis was troubling the world, and Washington was piling pressure on European policymakers to take firm action to stabilise the crisis.
Today, it will be a more confident Mr Trichet who addresses the central bankers’ summit in Jackson Hole, in the US. In Germany, where the ECB is headquartered, the economy is powering ahead, with scant signs of anything more than a modest slowdown after an exceptional second quarter performance. Eurozone prospects overall have brightened as a result. For the global economy, a slowdown has been factored in – but a dangerous “double dip” is not foreseen.
Instead – at least from a European point of view - the onus is now on US policymakers to address the weaknesses in its economy. No doubt, Mr Trichet will be as charming as ever, but his perspective is different to that of his US hosts. Read more
An interesting new NBER working paper by Vasco Curdia of the New York Fed and Michael Woodford of Columbia University will likely feature on Ben Bernanke’s reading list as he ponders both the options for further Fed easing (should it be necessary) and the Fed’s eventual exit strategy from easy policy. Mr Woodford is one of the world’s top monetary economists and a former colleague of Mr Bernanke at Princeton.
Here is part of the abstract:
We distinguish between “quantitative easing” in the strict sense and targeted asset purchases by a central bank, and argue that while the former is likely be ineffective at all times, the latter dimension of policy can be effective when financial markets are sufficiently disrupted. Neither is a perfect substitute for conventional interest-rate policy, but purchases of illiquid assets are particularly likely to improve welfare when the zero lower bound on the policy rate is reached. We also consider optimal policy with regard to the payment of interest on reserves; in our model, this requires that the interest rate on reserves be kept near the target for the policy rate at all times.
To attempt to paraphrase these conclusions:
- Quantitative easing – e.g. buying Treasuries to increase bank reserves with no commitment to keep them high in the future – doesn’t work. Read more
Now it’s official. The Federal Reserve is definitely on guard about the possibility that it might have to ease monetary policy further in response to the sputtering US economic recovery, according to minutes of the Federal Open Market Committee meeting held in late June.
Here’s the key language: “Members noted that in addition to contuining to develop and test instruments to exit from the period of unusually accomodative monetary policy, the committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably”. Read more
The doves on the Federal Open Market Committee already have plenty of ammunition to argue against any early rate hikes or asset sales, given the slowdown in the economic recovery. But they have acquired an additional weapon with the release of the Institute for Supply Management’s monthly surveys on business activity in the services and manufacturing sectors.
Both the ISM services survey, released today, and the ISM manufacturing survey, released last Thursday, disappointed forecasters, revealing bigger-than-expected drops in activity. But that’s not all. The ‘price’ component of both surveys were sharply lower – a very concrete sign that disinflationary pressures are accelerating across the US economy.
The manufacturing ISM showed the prices index down from 77.5 to 57, while the services survey’s price index fell from 60.6 in May to 53.8 in June. Let’s not forget that core inflation - as measured by the labor department’s consumer price index excluding food and energy – rose by 0.9 per cent in the year to May - its slowest pace since 1966 and well below the Fed’s target of about 2 per cent.
Of course, the ISM price indices include Read more