The Fed's commitment to open-ended quantitative easing is more fragile than believed. That is my first takeaway from the minutes of the January FOMC meeting. My second takeaway follows from the first: If the Fed is already wavering on the pace of quantitative easing, can it be long before they waver on their commitment to low rates as well?
Step back to the statement from the January meeting. A central part of that statement was this sentence:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.
What exactly is "substantially"? We don't really know, but I would be hard-pressed to claim that the labor market has improved substantially. Improved, yes. Substantially, no. And the Fed seemed to agree. From the minutes:
In their comments on labor market developments, participants viewed the decline in the unemployment rate from the third quarter to the fourth and the continued moderate gains in payroll employment as consistent with a gradually improving job market. However, the unemployment rate remained well above estimates of its longer-run normal level, and other indicators, such as the share of long-term unemployed and the number of people working part time for economic reasons, suggested that the recovery in the labor market was far from complete.
And I don't think the subsequently released employment report would have altered this view substantially (there's that word again!), so there should be no reason to worry about changing the pace of asset purchases. But maybe instead we should focus on the next line in the FOMC statement:
In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
One would have thought the cost/benefit analysis had been completed when the Fed adopted open-ended QE and then followed by converting Operation Twist into additional QE. But apparently not. The cost/benefit line is the Fed's get-out-of-jail-free card; it allows them to unwind QE regardless of the progress in the labor market. And this shows up in the minutes.
The discussion begins with the beneficial effects of open-ended QE.
The Committee again discussed the possible benefits and costs of additional asset purchases. Most participants commented that the Committee's asset purchases had been effective in easing financial conditions and helping stimulate economic activity, and many pointed, in particular, to the support that low longer-term interest rates had provided to housing or consumer durable purchases. In addition, the Committee's highly accommodative policy was seen as helping keep inflation over the medium term closer to its longer-run goal of 2 percent than would otherwise have been the case. Policy was also aimed at improving the labor market outlook. In this regard, several participants stressed the economic and social costs of high unemployment, as well as the potential for negative effects on the economy's longer-term path of a prolonged period of underutilization of resources.
But the discussion turns negative quickly:
However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy. A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets, although a couple of other participants noted that there had been little evidence to date of such effects....
...Several participants emphasized that the Committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved. For example, one participant argued that purchases should vary incrementally from meeting to meeting in response to incoming information about the economy. A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.
Now, in all honesty, we should have seen this coming. Cleveland Federal Reserve President Sandra Pianalto:
While our policies have been effective, our experience with our asset purchase programs is limited, and, as a result, we must analyze their benefits and costs carefully. Over time, the benefits of our asset purchases may be diminishing. For example, given how low interest rates currently are, it is possible that future asset purchases will not ease financial conditions by as much as they have in the past. And it is also possible that easier financial conditions, to the extent they do occur, may not provide the same boost to the economy as they have in the past.
In addition to the possibility that our policies may have diminishing benefits, they also may have some risks associated with them. I will mention four: credit risk, interest rate risk, the risk of adverse market functioning, and inflation risk. These and other risks are not easy to see or measure, but they need to be taken into account when setting monetary policy.
First, financial stability could be harmed if financial institutions take on excessive credit risk by "reaching for yield" -that is, buying riskier assets, or taking on too much leverage-in order to boost their profitability in this low-interest rate environment. Second, interest rate risk could arise if financial companies are not prepared to manage the losses they might suffer by holding too many long-term, fixed-rate, low-yield assets when interest rates rise. Third, financial market functioning could, at some point, become distorted as a result of the Federal Reserve's large and growing presence in mortgage-backed securities and Treasury securities markets. And last, but certainly not least, there is the risk that the Federal Reserve's ability to respond to future inflationary pressures could be complicated by the size and composition of our balance sheet....
Federal Reserve Governor Jeremy Stein explores the issue of overheating in credit markets:
The third factor that can lead to overheating is a change in the economic environment that alters the risk-taking incentives of agents making credit decisions. For example, a prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage, in an effort to "reach for yield."
Robin Harding of the Financial TImes recently interviewed James Bullard, and came away with this:
US Federal Reserve officials fear a backlash from paying billions of dollars to commercial banks when the time comes to raise interest rates...
...Officials at the US central bank fear it could create a public-relations nightmare after the Fed was lambasted for rescuing banks during the financial crisis. It is one factor prompting some inside the Fed to reconsider the eventual "exit strategy" from easy monetary policy....
...Mr Bullard said that neither interest paid to banks nor possible losses on exit made any difference to the substance of monetary policy.
"I think it's more just a question of the optics, and how you're going to play the optics," he added, referring to the perception of losses by the central bank. "And since it shouldn't matter in a monetary policy sense you might as well play the optics in a better way than the one we've got planned."
Ways to play the optics include slowing the pace of asset purchases or accelerating the pace of sales when they occur. Harding reads the minutes and concludes:
The US Federal Reserve is cooling on open-ended asset purchases as officials grow nervous about the dangers of a bigger balance sheet.
You might find this discussion frustrating as the Fed sees a clear benefit from QE, yet only imaginary risks. See Matthew Yglesias. Still, some sanity prevailed:
Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee's commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee's exit principles, either as a supplement to, or a replacement for, asset purchases.
Some participants are rightly concluding the if the Fed's switches gears on QE too soon, market participants will get a wee bit nervous that the same will be true for interest rates. The key sentence in the statement:
In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
A rock-solid commitment to the Evans rule, correct? But, then again, maybe not. On to the next sentence:
In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
"Readings on financial developments" is a pretty opened-ended concept. In fact, one might argue that it pretty much allows the Fed to ignore the Evans rule entirely should they sense, for example, that investors are "reaching for yield." And where have I been hearing that lately?
In short, I question that there is an elegant way for the Fed to convince market participants that pulling back on QE for imaginary threats in the face of evidence of real benefits does not necessarily imply that they will also ignore the Evans rule when faced with additional imaginary threats.
Now, you should go read Cardiff Garcia, who is not so bleak as I, and concludes his analysis with:
But it would not mean that the Fed was preparing to undo its thresholds approach or reverse the other changes it made in the second half of last year. Eventually the markets would figure this out.
To which I would reply that the Fed could argue that they are not reversing their approach, they are simply exercising the stated option within that approach to address "readings on financial developments." Still, as Garcia notes:
All very speculative, of course, and today's minutes do confirm that those lingering communications issues remain unsolved.
Bottom Line: The minutes suggest the Fed is wavering on their commitment to QE. We should watch upcoming speeches for unequal weight in the benefits vs. costs discussion. If the weight shifts increasingly toward costs, a change may be close at hand. And if they exercise the cost/benefit clause to ignore the job market clause and alter the direction of the large scale asset purchase program, recognize that the Evan's rule also has its own open-ended clause for the Fed to place imaginary concerns over real outcomes. After all, when you are the central bank, what exactly does not come under the realm of "readings on financial developments?"