Federal Reserve Chairman Ben Bernanke took the stage Thursday, providing few hints about the path of monetary policy in the months ahead. Market participants were hoping for more specific details on what the Fed has up its sleeve at the next meeting, but got more of the same:
In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. My FOMC colleagues and I will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September and are prepared to employ these tools as appropriate to promote a stronger economic recovery in a context of price stability.
More interesting was his extended comments on inflation:
However, inflation is expected to moderate in the coming quarters as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs. Meanwhile, the step-up in automobile production should reduce pressure on car prices. Importantly, we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy. Longer-term inflation expectations have remained stable according to the indicators we monitor, such as the measure of households' longer-term expectations from the Thompson Reuters/University of Michigan survey, the 10-year inflation projections of professional forecasters, and the five-year-forward measure of inflation compensation derived from yields of inflation-protected Treasury securities. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.
A couple of points. First, he takes the inflation boogeyman off the table for the time being. Not only are temporary factors easing, but long-term expectations remain stable and wage gains are subdued. Focus more, however, on the inflation expectations story – clearly Bernanke is not phased by the deterioration in the five and ten year-forward breakevens. The ten year in particular still hovers well above the levels that triggered QE2.
So where are we at? The deterioration in the real economy coupled with moderating inflation suggests more easing is at hand. Indeed, we know there is a growing dovish FOMC group that desires more aggressive policy. But how aggressive? Chicago Federal Reserve President Charles Evans desires a relatively aggressive stance that includes allowing inflation to drift up to 3% at least temporarily. But I don’t think we will get something like that. And I can’t see a return to quantitative easing short of a real deflation threat – I don’t see the core of the FOMC or Bernanke himself supportive of such a step at this time. Ditto for allowing the inflation target to drift upward.
If higher inflation targets and an open-ended program of quanitative easing are off the table, what’s left? As I noted earlier this week, the usual suspects, with the extending the duration of the Fed’s portfolio high on the list of market expectations. See Neil Irwin's piece at the Washington Post.
What I have trouble seeing is a strong commitment about the path of monetary policy. More soft commitments, yes. But not a locked in stone, willing to endure higher inflation commitment. Consider, for example, this week’s speech by San Francisco Federal Reserve President John Williams. He seems open to additional policy:
Despite these efforts, the recovery slowed to a crawl this year. But what does this mean for monetary policy? After all, monetary policy cannot cure all that ails our economy, which in large measure involves the aftereffects of the mortgage lending boom, the housing crash, and the resulting financial crisis. But, monetary policy can help limit the damage and provide support to other areas of the economy.
Williams sounds supportive of additional action, which he made more clear in comments. Via Reuters:
"There's still considerable room for monetary accommodation to improve financial conditions," San Francisco Federal Reserve Bank President John Williams told reporters after a speech to the Rotary Club of Seattle. "My main concern is really not the concern that inflation is going to be too high over the medium term. I think my main concern really is the pace of recovery and the high degree of unemployment."
"If anything more monetary accommodation seems appropriate than not," he added.
Still, something dramatic, moving into the relm of Evans? Note the mixed message. Yes, there is more we can do to prevent the patient (his analogy later) from deteriorating further, but the medicine is limited. How does this play into monetary policy? He continues:
The monetary policy situation is similar. Like the hospital patient, the economy took a turn for the worse and faces heightened risks. In addition, inflation is expected to drift down. These circumstances called for additional monetary easing. At our August meeting, the FOMC took a step in that direction, issuing a statement that we are likely to keep the federal funds rate at exceptionally low levels at least through mid-2013.
Arguably, if data continues to disappoint heading into the next meeting, the same logic will hold true, and the Fed will embrace some additional easing. So far, so good. But then he undermines the FOMC statement, first by dismissing it relevance:
In one respect, this wasn’t such big news. Even before the announcement, financial market participants generally didn’t expect the Fed to raise rates much earlier than mid-2013.
Then he backtracks and claims:
But it was news in the sense that it removed uncertainty and helped financial markets better understand our intentions.
I like that, removing uncertainty is a good thing. But then he puts the uncertainty right back into the mix:
Note also that we are not tying our hands by making this announcement. We haven’t made a guarantee. We will alter our policy as appropriate if circumstances change.
When is a commitment not a commitment? When made by the Federal Reserve. Which makes me wary of any supposed policy guidelines. Most policymakers - even increasingly dovish ones such as Williams - don’t want to have their hands tied, and few other than Evans are interested in seeing inflation drift above 2%. Williams on inflation, via Bloomberg:
When asked by reporters whether he would be willing to tolerate higher inflation if it brought down unemployment, Williams said, “I don’t think there’s a tradeoff. I don’t think that’s really a choice we can make over the long term.”
“We have to focus on keeping inflation relatively low over the medium term and again keeping employment as close as we can to the maximum sustainable level,” he said.
Still others don’t believe additional policy will do much good. And quite frankly, I am sympathetic with that view. If the Fed is going to have an impact, policymakers need to go big time. 20 basis points on the long-end of the yield curve through a maturity extension just is not going to cut it. Allowing inflation to drift up to 3% is not going to cut it. Chopping the interest rate on reserves in half is not going to cut it. Half commitments to policy paths are not going to cut it. I am not even confident committing to a rate of 1% on the ten year will cut it, unless fiscal policymakers take advantage of such a gift and step up government spending. I am not sure the private sector will want to make many 1% loans – financial institutions need some spread to make a profit. These are all things that probably won’t hurt and should be tried, but don’t expect miracles either.
What would work? I am sympathetic to the notion that if fiscal policymakers can address the mortgage mess, then lower interest rates that encourage refinancing can help. But this isn't something the Fed can do alone. I am also sympathetic to targeting an asset price that you are very confident will stimulate demand. And that brings you to the hand played by the Swiss National Bank – commit to currency depreciation. Set a target for the dollar, and purchase foreign assets in unlimited quantities to achieve that goal.
Bottom Line: Bernanke continues to hold his cards close to his chest. The data flow, and the subsequent forecast implications, justifies additional easing. Indeed, Bernanke’s inflation view appears to take out one impediment to such easing. That said, the lack of concern about the path of longer-term inflation expectations still suggests additional easing will fall short of what we saw during last year's deflation scare. The composition of the portfolio seems high on the list, although I am hesitant to believe there is a lot of traction to be gained when the ten year rate is hovering around 2%. Steps in the right direction, to be sure, but, as Federal Reserve officials continue to emphasize, nothing that will rapidly restore economic vibrancy.