What Has The Fed Done Over The Past 2 Months?

Includes: IEF
by: Brad DeLong

Mark Thoma sends us to Tim Duy, who nails it:

A Pledge To Be Responsible:

Since the June FOMC meeting and subsequent press conference with Federal Reserve Chairman Ben Bernanke, monetary policymakers have bent over backwards to convince financial market participants that tapering quantitative easing does not imply an earlier date for the lift-off from the zero interest rate policy. It has been a hard message to sell…. When I read the latest speech by New York Federal Reserve President William Dudley, it seems evident to me that there has indeed been a shift in monetary policy.

The key sentence is this:

Taken together, the labor market still cannot be regarded as healthy. Numerous indicators, including the behavior of labor compensation and household assessments of labor market conditions, are all consistent with the view that there remains a great deal of slack in the economy.

The Fed adopted a 7% unemployment trigger for ending quantitative easing despite full recognition that a wide array of labor market indicators reveal a persistently weak and under performing labor market… in the face of decidedly weak inflation data. Why act to reduce accommodation when the Fed is missing so badly on both sides of its dual mandate?… The Fed intends to reduce accommodation now to prevent overheating in 2014. In effect, it is a promise to be responsible…. If the Fed is now a responsible central bank, should it be expected to maintain zero-interest rates well into 2015? Financial markets think the answer is "no," despite the Fed's statements otherwise. And possibly the answer is "no" with good reason….

The challenge is convincing market participants that the Fed's intends to allow… a period of irresponsible behavior from a conventional central banking perspective… one means of establishing this intent was quantitative easing…. By signalling an end to quantitative easing while the economy is still mired in a challenging economic environment, the Fed effectively communicated an intention of being responsible, and thus signaled that they would mostly likely choose to be responsible with interest rate policy as well, regardless of efforts to convince us otherwise.

Carola Conces Binder finds Jim Hamilton saying that no, monetary policy has not changed:

Prior to the Great Recession, I thought we had all agreed on the practical limits on the Fed's capabilities. We understood that to some extent the Fed could control the short-term interest rate by changing the supply of reserves available to the banking system. But we also understood that the Fed's influence over longer-term interest rates was much less immediate and direct. The Fed can communicate its long-run inflation objectives, and certainly the 10-year inflation rate is a very important determinant of long-term yields. But regardless of what the Fed may say about its 10-year inflation goals, the market would form its own view of whether the Fed could or would achieve those. Other determinants of long-term yields, such as the term premium, long-run economic growth rate, and global saving and investment decisions were understood to be even farther beyond those things that the Fed can hope to control.

And Jeremy Stein:

At best, we can help market participants to understand how we will make decisions about the policy fundamentals that the FOMC controls--the path of future short-term policy rates and the total stock of long-term securities that we ultimately plan to accumulate via our asset purchases. Yet as research has repeatedly demonstrated, these sorts of fundamentals only explain a small part of the variation in the prices of assets such as equities, long-term Treasury securities, and corporate bonds. The bulk of the variation comes from what finance academics call “changes in discount rates,” which is a fancy way of saying the non-fundamental stuff that we don’t understand very well--and which can include changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of internal market dynamics…. So while we have seen very significant increases in long-term Treasury yields since the FOMC meeting, I think it is a mistake to infer from these movements that there must have been an equivalently big change in monetary policy fundamentals.

There are four components to the system:

  1. The Federal Reserve's policy rule relating short-term safe nominal interest rates to unemployment, inflation, and financial risks: i = ƒ(u,π,φ)

  2. The future evolution of u,π,φ as driven by factors other than Fed policy.

  3. The reduced form produced by substituting out the Fed's reaction function from the system of (1) and (2).

  4. The asset market's long-term interest rates and break-evens as forecasts of the future evolution of i and π.

If, as James Hamilton claims, the recent jump in the forecasts of future short-term interest rates implicit in long bond rates were due to shifts in expectations of "the term premium, long-run economic growth rate, and global saving and investment decisions…farther beyond those things that the Fed can hope to control", he and I would both have expected the rise in ten-year Treasury rates to be accompanied by a smaller rise in ten-year TIPS and thus a rise in the inflation forecast provided by the ten-year break-even.

That ain't what happened: since winter, the inflation break-even has fallen from 2.5%/year to 2.0%/year, while the ten-year Treasury has risen from 2.0%/year to 2.5%/year:

Screenshot 7 4 13 11 01 AM

That's a monetary tightening!

If, as Jeremy Stein claims, the rise in ten-year rates was not due to the Fed's signals leading to changes in expected future policy but rather "changes in either investor sentiment or risk aversion, price movements due to forced selling by either levered investors or convexity hedgers, and a variety of other effects that fall under the broad heading of 'internal market dynamics'", then the movement in the inflation break-even tells us that the market thinks that the Federal Reserve is not going to respond appropriately to these "internal market dynamics". One of the principal jobs of the Federal Reserve is to keep fluctuations due to internal market dynamics from pushing the economy away from its proper path of high employment, stable prices, and rapid growth - and the break-even tells us that the Fed is failing in this mission.