On the surface, the Fed’s recent statement should not have been much of a surprise. It was remarkably consistent with Fed Chairman Ben Bernanke’s recent policy speech. And it leaves little illusion that the US economy is mired in anything but the worst recession since the Great Depression.
My takeaways from the statement were straightforward:
1) Since the effective funds rate was trading well below the Fed’s target, and it was economically unimportant in any event, just take the target to a range near zero. I assume that given the instability of financial markets, they thought it best not to prescribe a specific target, but a range instead.
2) The Fed committed to low rates indefinitely, giving market participants faith that they can extend Treasury purchases further out along the yield curve without fear of a sharp policy reversion in the near future. (Does the Fed’s commitment to low rates leave Treasuries as the last one way bet?)
3) Not surprisingly, economic weakness, not inflation, is the primary concern. There is no reason for near term optimism.
4) Policy will focus on the tools that reveal themselves in the Fed’s balance sheet. Those tools may be expanded to include outright purchases of longer dated Treasuries.
The final point is worth considering further, especially since the Fed brought forth a “senior Fed official” to elaborate on the statement. I don’t quite understand the need for secrecy – why not have Bernanke himself just step up to the plate? In any event, the secret official took pains to explain that this policy did not constitute quantitative easing. First, the statement:
The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.
What struck me on the first read was the commitment to maintain the balance sheet at a high “level.” I think the use of the word “level” was deliberate – quantitative easing implies a commitment to a steady expansion, or rate of change, in the balance sheet. The Fed is offering no such commitment at this time. Is this the proper interpretation? From the senior official:
The Fed said in its statement today that it will be using its balance sheet to support credit markets and the economy. Some analysts have called the approach quantitative easing — effectively expanding the money supply once interest rates cannot be eased further — as Japan did during its economic turmoil.
But the senior Fed official said the central bank’s approach is distinct from quantitative easing and different from what the Japanese did.
What, stop….the arrogance of Fed officials never ceases to amaze me! Note that this official accuses “[S]ome analysts” of misinterpreting the Fed’s policy stance. I have written on this in the past:
…What we have now is an expansion of the balance sheet to accommodate liquidity measures. This may pave the way to quantitative easing, but still maintains the Fed Funds rate as the primary target.
But then why do they keep saying they have a policy of quantitative easing? This first crossed my radar when reviewing a recent interview with Dallas Federal Reserve President Richard Fisher. I discounted his reference to quantitative easing as Fisher is something of a colorful character who often talks before he thinks. But subsequent policymakers repeated the term. Earlier this week New York Fed President Gary Stern was quoted by Stephen Beckner:
Asked whether the doubling in size of the balance sheet represents "quantitative easing," Stern said "I don't think that's a bad statement. I think the world is a little more complicated than that, but I don't think that's a bad statement."
So, just to be clear, it is not just “some analysts” who are confused by the Fed’s policy – the confusion spills over to Fed policymakers as well. Maybe analysts would not be confused if Fed officials would simply stick to one set of talking points.
According to the official, we are not in the realm of quantitative easing. What is the distinction?
The Fed’s balance sheet has two sides, the official explained: assets with securities the Fed holds (including loans, credit facilities, mortgage-backed securities) and liabilities (cash and bank reserves). Japan’s quantitative easing program focused on the liability side, expanding cash in the system and excess reserves by a large amount. The Fed’s focus, however, is on the asset side through mortgage-backed securities, agency debt, the commercial paper program, the loan auctions and swaps with foreign central banks. That’s designed to improve credit-market functioning, the official said. By expanding the balance sheet by making loans, the official explained, the focus is not on excess reserves but on the asset side. That securities-lending approach directly affects credit spreads, which is the problem today — unlike Japan earlier, where the problem was the level of interest rates in general, the official said.
Fed policy has been directed at improving credit market functioning, thereby acquiring assets, of which the expansion of liabilities is simply a side effect of the policy, not the policy itself. The Fed apparently views deliberate expansion of liabilities – a commitment of x% growth in some monetary aggregate via Treasury purchases – as quantitative easing. A commitment to increase the balance sheet at a steady pace (the first derivative) rather than maintain a high level. We are not there yet.
Is this distinction important? Or just semantics? I believe it is important, as the latter, a move to target the liabilities side of the balance sheet, would imply that the Fed is deliberately trying to stoke an inflationary fire. This may become the future policy, but for now the Fed is simply trying to keep the financial system from collapsing. Inflation would be an accident, not a deliberate policy effort, at least from the Fed’s point of view. For the moment, the policy remains insufficient to ward off deflationary pressures as long as the rest of the world refuses to accept the burden of global adjustment.
The problem, in my mind, is that the rest of the world either refuses or is simply incapable of shouldering some of the burden of global adjustment. This inability to adjust appears to be the end result of almost thirty years of global acceptance and US indifference to external imbalances. Global consumption and production patterns, both spacially and intertemporally, are so misaligned that it looks like we are all now in a race to the bottom together. An amazing global policy failure. So, so depressing.
So when does Fed policy truly become inflationary? Currently, I am thinking it becomes inflationary when policymakers become desperate enough to attempt to use monetary policy to entirely offset the headwinds blowing against economic activity. When they truly attempt to target asset prices to “fix” the housing market. When they decide the easiest answer to the excessive build up of debt is to inflate it away. At that point, policy will shift from the asset side of the balance sheet to the liability side. That is when Treasury and the Fed will risk a disorderly adjustment of the dollar. Hopefully we will not get there. But I suspect that is when the tide will turn for the Fed.