As is well known, policymakers have been coalescing around a QE exit strategy for some time, since at least the March FOMC meeting. Two central issues with the exit are the timing and the communications. Officials do not want to undermine the recovery, knowing full-well that previous flirtations with exits have gone awry. At the same time, however, they fear the cost-benefit analysis may be turning against them. For some doves it is not the potential inflation cost, but the potential financial instability cost. Some policymakers want to begin tapering asset purchases at the next meeting, some are looking to the summer, and others looking to the fall.
Regarding the communications issue, policymakers seem to be taking pains to make clear that the financial markets should not overreact to any one policy move. The tapering process may be smooth, it may be choppy, it may be long, it may be short. It is contingent on the state of the economy, something inherently unknown. Mostly, they want to avoid a 1994-type of miscommunication.
Today's speech by Philadelphia Federal Reserve President Charles Plosser covers nearly all of these elements. In general, although I do not agree with his conclusions regarding timing, I think he makes a what would be viewed by some as a credible argument for tapering to begin sooner than later.
Begin with his base forecast:
My forecast of 3 percent growth should allow for continued improvements in labor market conditions, including a gradual decline in the unemployment rate, similar to the trend we have seen over the past three years, which was a 0.7- to 0.8-percentage point decline per year. Continuing at such a pace would lead to an unemployment rate close to 7 percent at the end of 2013 and a rate below 6.5 percent by the end of 2014.
Indeed, this year we have already seen the unemployment rate fall from 7.9 percent in January to 7.5 percent in April. Employers added 165,000 jobs in April, but the more positive news came in the revisions for February and March. The revised data indicate that firms added 332,000 jobs in February and 138,000 in March. The upward revisions for these two months added 114,000 jobs.
The forecast of a 6.5% unemployment rate by the end of 2014 is important. My thought is that the Fed will want to conclude asset purchases before hitting that target. Moreover, optimally they would like time so that, if necessary, the tapering can be a slow process. That argues for tapering to begin sooner than later. Indeed, Plosser would like asset purchases to end this year:
Based on the stated views of the Committee regarding the flexibility in pace of purchases, I believe that labor market conditions warrant scaling back the pace of purchases as soon as our next meeting. Moreover, unless we see a significant reversal in current trends that jeopardizes my forecast of near 7 percent unemployment rate by the end of this year, then I anticipate that we could end the program before year-end. Let's look at some of the data.
The end of the year is actually fast approaching; if you want to taper off over the course of a hand full of meetings, the calendar is driving you to begin now. Now, back to that data:
In the six months through September 2012, when the decision to initiate the latest open-ended asset purchase program was made, nonfarm payrolls had increased an average of 130,000 per month, and the unemployment rate had averaged 8.1 percent. In the most recent six months, from November 2012 through April 2013, nonfarm payrolls have increased on average 208,000 per month — a 60 percent increase — and the unemployment rate has averaged 7.7 percent. As I noted earlier, April's unemployment rate has now reached 7.5 percent.
Moreover, the average duration of unemployment has fallen, the share of long-term unemployment has dropped, and hours worked and earnings have risen. While further progress would certainly be desirable, I believe the evidence is consistent with a significantly improving labor market. Thus, it is appropriate to begin scaling back the pace of asset purchases.
At this point, I raise my hand and say "But isn't underemployment still too high and being driven by cyclical factors? Aren't you erring on the side of removing stimulus too early?" But that arguement is neither here nor there for Plosser. He has obviously decided these are second-order issues. He does deliver what (I think) is a novel argument for tapering sooner than later:
Indeed, in my view, were the FOMC to refrain from reducing the pace of its purchases in the face of this evidence of improving labor market conditions, it would undermine the credibility of the Committee's statement that the pace of purchases will respond to economic conditions. Similarly, if there were sufficient evidence that conditions in labor markets had deteriorated, I would expect the FOMC to consider increasing the pace of purchases. After all, this is the meaning of state-contingent monetary policymaking. But if we reach the point that markets only expect us to move in one direction — that is, toward more easing — and we become reluctant to dial back on purchases over concerns of disappointing or surprising markets, then we will find ourselves in a very difficult position going forward.
In short, the Fed communicated a particular strategy - one in which the pace of asset purchases would be determined by recovery in the labor market. And, by Plosser's reckoning, the 60% increase in the pace of job growth is evidence of exactly the kind of improvement the Fed was looking to achieve.
Notice that Plosser is not appealing to a fear that the Fed's credibility on inflation is at risk. Instead, not acting to slow asset purchases undermines the credibility of the Fed's communications strategy. This is an argument that might resonate with other policymakers who are already worried that financial markets will misinterpret future policy actions. I suspect Plosser knows inflation concerns are likely to fall on deaf ears. Indeed, he addresses the inflation topic earlier in the speech:
Should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term. However, I do believe that our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target.
Convincing others to pull back on easing due to inflation concerns is something of a challenge when your preferred inflation measure is below target and trending down. But where that argument fails, perhaps a credibility/communications argument can succeed?
Plosser is careful to add the now required "not tightening" clause:
I want to emphasize that in this state-contingent framework, reducing the pace or even ending asset purchases need not be the start of an exit strategy or more aggressive tightening. Nor would it indicate that an increase in the policy rate was imminent. Instead, these actions would slow and then halt efforts to continuously expand the level of accommodation by increasing the size of the balance sheet. Given the improving economy, dialing back asset purchases is an appropriate response.
I imagine we will see something like this in every speech going forward. Policymakers do not want market participants to jump to conclusions on the basis of any one policy move.
Bottom Line: While the Fed is moving closer to tapering asset purchases, timing remains an issue. I think that most policymakers will not be swayed to an early end by the "Fed's inflation credibility is at risk" argument. But a subset is likely swayed by the "financial stability is at risk" argument. And another subset may be swayed by the "communications credibility is at risk argument" that is an element of Plosser's speech. In short, the majority favoring continuing asset purchases at the current pace is obviously shrinking. Hopefully this week's upcoming speech by Federal Reserve Chairman Ben Bernanke and the release of the minutes from the last FOMC meeting will help clarify how quickly that majority is losing ground.