I want to make some quick comments - disjointed as they may be - on the minutes of the December 2013 FOMC meeting.
Near the beginning of the minutes, the staff presents a survey on the expected costs and benefits of the asset purchase program. I feel I need to highlight this section since I have complained that the Fed is leaving us in the dark on the cost/benefit calculus. Now I know why they are leaving us in the dark - they are pretty much in the dark themselves. They sense that the math still favors ongoing purchases:
Most participants judged the marginal costs of asset purchases as unlikely to be sufficient, relative to their marginal benefits, to justify ending the purchases now or relatively soon; a few participants identified some possible costs as being more substantial, indicating that the costs could justify ending purchases now or relatively soon even if the Committee's macroeconomic goals for the purchase program had not yet been achieved.
Still, they are worried about financial stability:
Participants were most concerned about the marginal cost of additional asset purchases arising from risks to financial stability, pointing out that a highly accommodative stance of monetary policy could provide an incentive for excessive risk-taking in the financial sector.
And they really don't know what they are doing:
It was noted that the risks to financial stability could be somewhat larger in the case of asset purchases than in the case of interest rate policy because purchases work in part by affecting term premiums and policymakers have less experience with term premium effects than with more conventional interest rate policy.
Some continue to think of the Fed's balance sheet like that of a regular bank:
Participants also expressed some concern that additional asset purchases increase the likelihood that the Federal Reserve might at some point suffer capital losses.
But common sense prevails:
But it was pointed out that the Federal Reserve's asset purchases would almost certainly provide significant net income to the Treasury over the life of the program, especially when the effects of the program on the broader economy were taken into account, and that potential reputational risks to the Federal Reserve arising from any future capital losses could be mitigated by communicating that point to the public.
I think it silly to complain about potential future losses without acknowledging the current profits; the asset purchase program needs to be evaluated across its entire lifespan. Moreover, it's silly to think the Federal Reserve needs to make a "profit" as if it were a regular bank. The Federal Reserve does not exist to make a profit. It exists to conduct the monetary policy of the nation. But I digress. In any event, policymakers should actually understand this, and hopefully recognize that the only reason for concern on this point is the public optics.
Then comes the issue of exit:
Further, participants noted that ongoing asset purchases could increase the difficulty of managing exit from the current highly accommodative policy stance when the time came.
But in general they feel prepared:
Many participants, however, expressed confidence in the tools at the Federal Reserve's disposal for managing its balance sheet and for normalizing the stance of policy at the appropriate time.
The success with the "reverse repo" facility (noted in the minutes) probably bolsters their confidence on this point. Regarding the benefits of the program, they understand the communications value of quantitative easing:
Regarding the marginal efficacy of the purchase program, most participants viewed the program as continuing to support accommodative financial conditions, with a number of them pointing to the importance of purchases in serving to enhance the credibility of the Committee's forward guidance about the target federal funds rate.
Still, their faith in the program is wavering:
A majority of participants judged that the marginal efficacy of purchases was likely declining as purchases continue, although some noted the difficulty inherent in making such an assessment.
Basically, they don't really have any basis for quantifying the marginal benefits of the program now. That said, there is push back:
A couple of participants thought that the marginal efficacy of the program was not declining, as evidenced by the substantial effects in financial markets in recent months of news about the likely path of purchases.
The great QE debate of 2013 was evidence of the program's communication value, but arguably if they change the policy mix such that communication is provided by forward guidance, then the benefits of the asset purchase program will fade, and with them the rationale for the program. Overall, I don't see a lot of cohesion around any method to quantify the cost / benefit trade-off of the program. It seems they are just taking the position that they will know the math has shifted against the program when they see it. Which, of course, makes assessing their likely policy path something of a challenge.
Participants still struggle with the reasons for the drop in labor force participation. Structural or cyclical? Really just covering much of the same ground:
Some participants cited research that found that demographic and other structural factors, particularly rising retirements by older workers, accounted for much of the recent decline in participation. However, several others continued to see important elements of cyclical weakness in the low labor force participation rate and cited other indicators of considerable slack in the labor market, including the still-high levels of long-duration unemployment and of workers employed part time for economic reasons and the still-depressed ratio of employment to population for workers ages 25 to 54. In addition, although a couple of participants had heard reports of labor shortages, particularly for workers with specialized skills, most measures of wages had not accelerated. A few participants noted the risk that the persistent weakness in labor force participation and low rates of productivity growth might indicate lasting structural economic damage from the financial crisis and ensuing recession.
The healthy debate on this topic likely leaves them wary to change the unemployment threshold. Unsurprisingly, inflation was also a topic of conversation. They remain convinced that the current trend will soon be reversed:
Inflation continued to run noticeably below the Committee's longer-run objective of 2 percent, but participants anticipated that it would move back toward 2 percent over time as the economic recovery strengthened and longer-run inflation expectations remained steady.
That said, there were broad concerns on this outlook:
Nonetheless, many participants expressed concern about the deceleration in consumer prices over the past year, and a couple pointed out that a number of other advanced economies were also experiencing very low inflation. Among the costs of very low or declining inflation that were cited were its effects in raising real interest rates and debt burdens. A few participants raised the possibility that recent declines in inflation might suggest that the economic recovery was not as strong as some thought.
Inflation isn't just low in the United States - it's low in many parts of the world. Europe, in particular, comes to mind. They must be concerned that low inflation abroad will translate to low inflation at home, even if the economy is strengthening as expected. And then there is another possibility. Although everyone is getting warm and fuzzy about the pace of the recovery, perhaps the inflation numbers are telling the real story. I still think it is odd that they overlooked such concerns and pulled the trigger on the taper-- justifying it, as I thought they would-- with the forecast and stable inflation expectations. Indeed, the inflation concern was prominent in the taper debate:
...most participants saw a reduction in the pace of purchases as appropriate at this meeting and consistent with the Committee's previous policy communications. Many commented that progress to date had been meaningful, and some expressed the view that the criterion of substantial improvement in the outlook for the labor market was likely to be met in the coming year if the economy evolved as expected. However, several participants stressed that the unemployment rate remained elevated, that a range of other indicators had shown less progress toward levels consistent with a full recovery in the labor market, and that the projected pickup in economic growth was not assured. Some participants also questioned whether slowing the pace of purchases at a time when inflation was running well below the Committee's longer-run objective was appropriate. For some, the considerable slack remaining in the labor market and shortfall of inflation from the Committee's longer-run objective warranted continuing asset purchases at the current pace for a time in order to wait for additional information confirming sustained progress toward the Committee's objectives or to promote faster progress toward those objectives.
Ultimately, the tiny taper combined with discretion in the pace of future reductions won the day:
Among those inclined to begin to reduce the pace of asset purchases at this meeting, many favored a modest initial reduction accompanied by guidance indicating that decisions regarding future reductions would depend on economic and financial developments as well as the efficacy and costs of purchases. Some other participants preferred a larger reduction in purchases at this meeting and future reductions that would bring the program to a close relatively quickly. A few proposed that the Committee lay out, either at this meeting or subsequently, a more deterministic path for winding down the program or that it announce a fixed amount of additional purchases and an expected completion date, thereby reducing uncertainty about the trajectory of the purchase program.
They simply were uncertain enough about the cost and benefits of the asset purchase program that they wanted to use the "progress toward goals" provision as an excuse to do a trial run on the exit.
Stepping back a bit in the minutes, the issue of financial stability makes another appearance:
Participants also reviewed indicators of financial vulnerabilities that could pose risks to financial stability and the broader economy. These indicators generally suggested that such risks were moderate, in part because of the reduction in leverage and maturity transformation that has occurred in the financial sector since the onset of the financial crisis.
What are policymakers looking for?
In their discussion of potential risks, several participants commented on the rise in forward price-to-earnings ratios for some small-cap stocks, the increased level of equity repurchases, or the rise in margin credit. One pointed to the increase in issuance of leveraged loans this year and the apparent decline in the average quality of such loans.
And what will financial stability issues means for future policy? Read carefully:
A couple of participants offered views on the role of financial stability in monetary policy decisionmaking more broadly. One proposed that the Committee analyze more explicitly the potential consequences of specific risks to the financial system for its dual-mandate objectives and take account of the possible effects of monetary policy on such risks in its assessment of appropriate policy. Another suggested that the importance of financial stability considerations in the Committee's deliberations would likely increase over time as progress is made toward the Committee's objectives, and that such considerations should be incorporated into forward guidance for the federal funds rate and asset purchases.
The idea of using monetary policy tools to combat financial instability is in its infancy, but is certainly something to watch. My sense is the majority of the FOMC believes they can address financial stability via macroprudential regulation. Hence I believe the Fed is a long way from turning the dual-mandate of monetary policy into a triple-mandate. But the baby was born alive and well on Constitution Ave.
Finally, the idea of lowering the unemployment thresholds was considered and rejected in favor of enhanced forward guidance:
Participants debated the advantages and disadvantages of lowering the unemployment rate threshold provided in the forward guidance. In the view of the few participants who advocated such a change, a lower threshold would be a clear signal of the Committee's intentions and was an appropriate adjustment in light of recent labor market and inflation trends. In contrast, a few others expressed concern that any change in the threshold might be confusing and could undermine the credibility of the Committee's forward guidance. Most were inclined to retain the current thresholds for the unemployment and inflation rates and to instead provide qualitative guidance regarding the Committee's likely behavior after a threshold was crossed.
Bottom Line: I am not sure the minutes provide many surprises. Overall, I think they reveal a very divided Federal Reserve, and the result is that every policy choice is a middle ground. This strikes me as a recipe for policy inertia. No abrupt changes to the pace of tapering. No abrupt changes to the interest rate outlook. No abrupt changes to the Evans rule. But I wonder if the middle ground is more like a knife edge - that general policy fatigue means the FOMC would shift its stance rapidly if the data broke decisively higher. This, I think, is something that might keep a bond trader up at night.