Federal Reserve speakers were out in force this weekend at the American Economic Association's annual meeting in Philadelphia. The first rumblings from Fed speakers came from the hawkish-side of the aisle. Via MarketWatch:
Philadelphia Fed President Charles Plosser warned Friday that the central bank may have to be "aggressive" in lifting interest rates and may have to chase market rates higher, if banks were to quickly release reserves. He also suggested the expectations of his colleagues by the end of 2016 that calls for Fed funds rates to be below 2% even when the job market is back to normal may be too low.
This should come as no surprise - Plosser has tended to be wary of the Fed's accommodative stance. There is nothing here we don't already know. As it stands today, the Fed is comfortable with a steep yield curve. They are willing to tolerate rising long-rates to the extent that the increases are not driven by shifting expectations of Fed policy. But clearly, if the economic circumstances improve markedly, the Federal Reserve will be inclined to raise short-term rates sooner than expected. That's how monetary policy works. So all Plosser is telling us is that his inflation forecast differs from the FOMC as a whole, and if his forecast is realized, then policy will change accordingly.
More interestingly, in a later speech Plosser challenged incoming Federal Reserve Chair Janet Yellen's preferred policy framework:
...there are several different ways to interpret the economic dynamics we have seen in recent years, and those perspectives would call for different policy responses. Some view the shocks hitting the economy as transitory and potential GDP as stable. Others view the shocks as being more permanent, affecting both actual and potential output.
In addition, there are alternative concepts of the output gap itself, some of which focus on the efficient level of output instead of potential output...
This state of affairs has led me to be skeptical of relying on gaps in general as well as optimal control exercises that are derived from specific models. Instead, I have long advocated that we should think in terms of robust policies that yield good economic outcomes across a variety of models and frameworks.
What such framework would Plosser suggest? From 2010:
So, if we have problems in measuring output gaps, what type of rule should we use? I believe it makes more sense to use an interest rate rule that responds aggressively to movements in inflation relative to a target and, if it responds to real economic activity, responds to a measure of the change in economic activity itself rather than some deviation from unobserved potential.
But, but, but...why then is Plosser so hawkish? Inflation has been moving away from target, so it would seem that he should be taking a dovish stance. How exactly is he going to mount a challenge to a Yellen Fed's basic policy approach? By jointly arguing that policy is too loosely and suggesting a rule that, if followed, would loosen policy further? I am just not seeing it, and thus not seeing how Plosser would be effective in affecting Fed policy. As such, I am not convinced that Plosser's ascension to voting status this year will make much difference other than providing journalists / economists / etc. with a dissenting voice.
Outgoing Federal Reserve Chair Ben Bernanke took his victory lap with an overview of his tenure. Too much here to cover adequately in this post, so I will skip to some of his comments on tapering:
...the FOMC's decision to modestly reduce the pace of asset purchases at its December meeting did not indicate any diminution of its commitment to maintain a highly accommodative monetary policy for as long as needed; rather, it reflected the progress we have made toward our goal of substantial improvement in the labor market outlook that we set out when we began the current purchase program in September 2012.
No surprise here either. The Fed has been pushing to divorce asset purchases from interest rate policy, and are cautiously optimistic they have done so successfully. Regarding the ability of the Federal Reserve to extricate itself from its current position:
Once the economy improves sufficiently so that unconventional tools are no longer needed, the Committee will face issues of policy implementation and, ultimately, the design of the policy framework. Large-scale asset purchases have increased the size of our balance sheet and created substantial excess reserves in the banking system. Under the operating procedures used prior to the crisis, the presence of large quantities of excess reserves likely would have impeded the FOMC's ability to raise short-term nominal interest rates when appropriate. However, the Federal Reserve now has effective tools to normalize the stance of policy when conditions warrant, without reliance on asset sales. The interest rate on excess reserves can be raised, which will put upward pressure on short-term rates; in addition, the Federal Reserve will be able to employ other tools, such as fixed-rate overnight reverse repurchase agreements, term deposits, or term repurchase agreements, to drain bank reserves and tighten its control over money market rates if this proves necessary. As a result, at the appropriate time, the FOMC will be able to return to conducting monetary policy primarily through adjustments in the short-term policy rate.
All sounds so easy, doesn't it? In contrast, Mike Derby at the Wall Street Journal reports that the person responsible for making it happen isn't quite so confident:
Speaking as part of a panel in Philadelphia on the activities of the regional Fed banks, Mr. Dudley acknowledged a lot is still unknown about how the bond buying works. His observation is important because he has long been a supporter of aggressive Fed actions to help the economy.
The New York Fed leader has for some time expressed support for continuing the purchases, even as he also voted in favor of the Fed's decision last month to cut back.
Referring to the Fed's stimulus program, Mr. Dudley said, "we don't understand fully how large-scale asset-purchase programs work to ease financial market conditions-is it the effect of the purchases on the portfolios of private investors, or alternatively is the major channel one of signaling?"...
...Mr. Dudley also said that when it comes time to unwind the Fed's easy-money stance, uncertainty is again a major issue facing central bankers.
"There could be unintended consequences" about moving to a more normalized state of monetary policy, he said.
I tend to think that such uncertainty runs deeper than it appears at the Fed, which is why policymakers are eager to end asset purchases. The more they buy, the more they risk "unintended consequences" at exit time.
Bernanke also threw cold water on the long-run forecast even as his was relatively optimistic for faster growth in 2014:
For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped...The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.
Richmond Federal Reserve President Jeffery Lacker offered similar concerns:
...Adding up all these categories of spending yields a forecast for GDP growth of just a little above 2 percent - not much different from what we've seen for the last three years.
That's my forecast for this year, but when thinking about growth prospects, I believe it's important to keep an eye on longer-run trends as well. To do that, it's useful to break down real GDP growth into the sum of the growth in labor productivity - that is, output per worker - and the growth in the number of workers. It turns out both of these components have slowed since the Great Moderation. If growth in overall output is going to rise substantially, then we would need to see an increase in labor productivity growth, or in employment growth, or both.
Lacker sees 1% growth in both labor force and productivity combining to deliver roughly 2% underlying growth for the near future, which is also his 2014 forecast - he is less optimistic about a cyclical burst of activity than Bernanke. The central issue is that there is widespread uncertainty about the breakdown of cyclical versus structural factors in the current environment. This is not an impediment to accommodative policy with unemployment at 7%. And the Fed forecasts give the cyclical issues the benefit of the doubt, which allows for policymakers to believe they can delay any rate hikes until 2015. But the uncertainty over the structural / cyclical divide is sufficient to prevent policymakers from dropping the unemployment threshold to 6% or lower and shifting their forward guidance from a forecast to a promise. As of yet, there is no replacement for the Evan's rule, leaving forward guidance more vulnerable to challenges from markets. Markets get ahead of the Fed, Fed beats them back, markets get ahead of the Fed, etc.
Bottom Line: Fedspeak over the weekend was generally consistent with my priors. Policymakers don't want to undershoot the recovery, but I don't sense they want to overshoot either. That points toward cautious withdrawal of accommodation. Pencil in somewhat stronger growth in 2014. Pencil in a steady reduction in the pace of asset purchases until the program winds down at the end of the year. Pencil in an extended period of low rates. But also recognize that the tide of monetary policy is now receding - albeit ever so slightly - with the Fed's first step of ending the asset purchase program. They don't want to do more if they can avoid it, and I don't think the risks are weighted toward a reversal of their current expected policy path. The data flow would need to turn sharply weaker to prompt the Fed to turn tail and increase the pace of asset purchases. Same too, I think, for changing the unemployment threshold. They would need to be very confident that a new threshold was not locking them into a policy they thought to be too accommodative.
Instead, I tend to think the risks are weighted in the other direction, that a positive change in the pace of activity would precipitate a more aggressive withdrawal of accommodation. This is especially the case given the Fed's concerns over the size of the balance sheet, uncertainty with regards to the degree of structural changes to the economy, and resulting hesitancy to lower the unemployment threshold. That said, there will be limits to the degree of hawkishness the Fed would be willing to adopt in the absence of a real change in the inflation outlook. The challenge for the Fed will be containing the idea of a more hawkish policy stance to a risk to the outlook, rather than allowing it to become the baseline scenario. With the high tide of policy now in the past, and the discussion turning back to when will policymakers do less, expect financial market participants to keep testing and retesting policymaker resolve.