Out of the contentious meeting evident in the most recent FOMC minutes comes a narrative of the tapering debate, a debate that, for the moment, the hawks lost. The opportunity to take even a baby step to ending asset purchases slipped away. Because after the September meeting, the door closed on tapering for at least three more months, and probably longer.
Back in February Governor Jeremy Stein presented an important speech on the interplay between monetary policy and financial stability. Notably:
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."
While Stein emphasizes separating monetary policy tools from financial stability tools, he concludes:
Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability. Let me offer three observations in support of this perspective.
One such reason:
Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument. We can do more than adjust the federal funds rate. By changing the composition of our asset holdings, as in our recently completed maturity extension program (MEP), we can influence not just the expected path of short rates, but also term premiums and the shape of the yield curve. Once we move away from the zero lower bound, this second instrument might continue to be helpful, not simply in providing accommodation, but also as a complement to other efforts on the financial stability front.
Asset purchases are both a financial stability tool and a monetary policy tool. You can quickly see how policy would evolve with this view of asset purchases. If QE is creating financial stability issues, then policymakers would need to exit from QE while finding another tool to hold net accommodation constant. Thus is born an emphasis on forward guidance regarding the path of the Federal Funds rate as a replacement for asset purchases. A change in the policy mix, not the level of accommodation.
Hawkish Federal Reserve regional presidents must have been ecstatic at the potential for this policy shift among the governors. There has also been a group opposed to QE, particularly the open-ended version. Names such as Fisher, Plosser, Lacker and George come to mind. But a critical center of the FOMC, the governors, have tended to favor the program. But with that changing, an opportunity to end QE suddenly came into view.
Indeed, as we now know from Jon Hilsenrath's work, the anti-QE crowd was not limited to Stein, but also included Governors Powell and Duke. And I am guessing Federal Reserve Chair Ben Bernanke did not try to stop the anti-QE train. Did Vice Chair Yellen? Unknown. But by April momentum toward QE was growing enough that San Francisco Federal Reserve President John Williams predicted that tapering could begin as early as June of this year. I said at the time:
Based on William's current forecast, he expects the Fed will begin tapering off asset purchases this summer, perhaps the June FOMC meeting. He is apparently more optimistic than me, as this puts him at least three months ahead of my expectations - I had not anticipated slowing the pace of purchases until late in the year.
By June, the anti-QE momentum had gained further, with the end result that Bernanke turned decidedly hawkish at the post-FOMC press conference, laying out the path to ending asset purchases and even throwing down a 7% unemployment trigger. I have to imagine he wishes he hadn't given a firm number as that part of the Fed's forecast was too pessimistic.
Although Fed speakers tried to hold back expectations on Fed tapering and emphasize the data dependent program, expectations for tapering continued to build. The problem was that while the data was lackluster, it was hard to say that is was not "broadly consistent" with the Fed's forecast. Moreover, few policymakers were willing to step in front of the tapering train, with the exception of Minneapolis Federal Reserve President Narayana Kocherlakota. The lack of obvious doves was noted by Reuters journalist Pedro DaCosta in the wake of Jackson Hole.
Indeed, if New York Federal Reserve President William Dudley had made this speech prior to the September meeting, the tapering expectations train would have ground to a halt. Why didn't he or others? Possibly because they did not know what resistance they would face from anti-QE governors at the meeting. The governors talk infrequently. Could any regional president really know how thought was evolving inside the Board? Best to be quiet than be wrong. But market participants mistook quiet for acquiescence.
Policy hawks likely saw everything moving in their direction at the September FOMC meeting began. To be sure, the data was marginal. But the markets were fully expecting a small taper! The FOMC was getting a free pass for a small taper. They could match the taper with a dovish statement, and market participants would eat it up with a smile. The timing would never be better.
But the dove didn't roll over:
In general, those who preferred to maintain for now the pace of purchases viewed incoming data as having been on the disappointing side and, despite clear improvements in labor market conditions since the purchase program's inception in September 2012, were not yet adequately confident of continued progress. Many of these participants had revised down their forecasts for economic activity or pointed to near-term risks and uncertainties.
The fight must have been, as far as recent FOMC meetings are concerned, bordering on epic. Hawks responded forcefully:
The participants who spoke in favor of moderating the pace of securities purchases at this meeting also cited the incoming data, but viewed those data as broadly consistent with the Committee's outlook for the labor market at the time of the June FOMC meeting when the contingent expectation that the pace of asset purchases would be reduced later in the year was first presented to the public. Moreover, they highlighted what they saw as meaningful cumulative progress in labor market conditions since the purchase program began. Those participants generally were satisfied that investors had come to understand the data-dependent nature of the Committee's thinking about asset purchases, and, because they judged that the conditions laid out in June had been met, they believed that the credibility of the Committee would best be served by announcing a downward adjustment in asset purchases at this meeting. With the markets apparently viewing a cut in purchases as the most likely outcome, it was noted that the postponement of such an announcement to later in the year or beyond could have significant implications for the effectiveness of Committee communications. In particular, concerns were expressed that a delay could potentially undermine the credibility or predictability of monetary policy by, for example, increasing uncertainty about the Committee's reaction function and about its commitment to the forward guidance for the federal funds rate, with the result of an increase in volatility in financial markets. Moreover, maintaining the pace of purchases could be perceived as a sign that the FOMC had turned more pessimistic about the economic outlook.
And, probably most frightening to hawks, they saw that the door was about to close on tapering in the near term:
Finally, it was noted that if the Committee did not pare back its purchases in these circumstances, it might be difficult to explain a cut in coming months, absent clearly stronger data on the economy and a swift resolution of federal fiscal uncertainties.
It's not just difficult to explain a cut in the coming months. It just isn't going to happen. Stronger data? We no longer have any of the most important data. Swift resolution of fiscal uncertainties? That battle is even bloodier than that within the Fed. Moreover, the impending leadership change also argues for delaying tapering until 2014. Unless the economy lurches upward, what exactly is the reason to pull the trigger on tapering before the March FOMC meeting, after which future Chair Janet Yellen will lead a press conference? None, really.
Bottom Line: Any hawkish overtones in the FOMC minutes have been overtaken by events. The opportunity for even a small taper slipped through the hawks' talons. They should not be so unnerved. They pulled off a piece of flesh as they flew past their prey, triggering a substantial monetary tightening as the term premium jumped in response the tapering talk. Still doves are again ascendant for the moment. Not only does the budget/debt showdown put any tapering on indefinite hold, once again the Fed may be called upon to boost the pace of asset purchases should financial markets crack. And hawks are correct - the bottom range of "broadly consistent" is no longer good enough to justify tapering. Clearly, stronger data is needed. And that data is literally almost nowhere to be found.