In section 2a of The Federal Reserve Act, the monetary policy objectives of the Federal Reserve are, "... to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." This language, colloquially known as the "dual mandate," dictates that monetary policy must try to achieve maximum employment while keeping general price levels stable.
An examination of outcomes relative to these simple goalposts is a good predictor for the directionality of future monetary policy. How is the Fed doing on both the unemployment and inflation front?
Unemployment by all accounts is still extraordinarily high. While down from its 10% peak in October 2009, the 8.3% domestic unemployment rate is still higher than any pre-Great Recession print since December 1983.
click to enlarge
Unemployment is receding slowly, but even Federal Reserve Chairman Ben Bernanke recently conjectured that this rate understated the weakness in the labor market. Since the unemployment rate includes in the denominator only individuals who are employed or actively seeking employment, discouraged workers who might be seeking employment if labor markets were stronger are excluded.
Despite population growth, the labor force is still smaller than its pre-recession peak and roughly the same size as May 2005. Nine million fewer Americans are working today than in November 2007, a figure roughly the size of the population of New Jersey, our eleventh most populous state.
An even bleaker picture of unemployment might be the labor force participation rate, the proportion of the population that is in the labor force. Despite the continued emergence of two income households, this rate is at its lowest level in a generation. Given the fiscal headwinds facing the U.S. economy, the demographic might of the retiring Baby Boomer generation, and the need to right-size entitlement and social welfare spending, this negative trend only adds additional stress to the problems facing lawmakers.
The Federal Reserve's projections of the unemployment rate do not envision full employment at any point through their forecast horizon of 2014, which signals that likelihood of continued monetary accommodation.
In the same recent economic forecast, the Federal Reserve targeted core inflation to slow in 2012. Some private economists believe that temporal factors, such as oil price pressures related to the Arab Spring, pushed the general price level higher over the past several quarters and could dissipate in 2012.
Below is a histogram of the results of a Bloomberg survey of 53 private economists on their expectations for the year over year change in core personal consumption expenditures, which the Fed has indicated is the gauge most consistent with their long-run inflation mandate. The average forecast for 2012 of 1.69% and average forecast for 2013 (1.83%) are in line with the long run policy objectives of the Federal Reserve. Inflation expectations for the next one year as measured by a household survey conducted by the University of Michigan remain at just slightly less than their trailing five year average (3.3%), and remain well anchored.
Comparing the outlook for both sides of the Fed's dual mandate indicates that unemployment is undoubtedly the larger concern, which seems to favor at a minimum static policy, but potentially increased accommodation.
The Taylor Rule
To better gauge the output/employment and inflation tradeoff we turn to a modified version of the Taylor Rule. The Taylor Rule, first proposed by Stanford economist John Taylor in 1993, is a monetary policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation and output. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.
One of the chief criticisms of the Taylor Rule is that it can misguide policymakers who need real-time data in a quickly evolving economy. However, using validated data ex-post, we can determine where the Taylor Rule would have indicated the level of the nominal interest rate.
Using the Inflation/Unemployment Gap Model with a 2% neutral real rate, Core PCE of 1.8% as actual inflation, 2% as target inflation, an Okun Factor of 2, and NAIRU of 5%, we get a Taylor Rule estimate of 0.4%. More notably, a retrospective examination of the Taylor Rule indicates that the Fed Funds rate should have been negative for two years, potentially justifying further easing.
Bernanke and Deflation
Quantitative easing is an unconventional monetary policy tool. The Federal Reserve has expanded its balance sheet in part because of the fragility of the financial system, and in part because it feared a deflationary spiral that could prove disastrous given the run-up in debt levels in the household and government sectors. Bernanke is undeniably a deflation hawk. Nearly ten years ago, the then Fed Governor gave a speech to the National Economists Club against the specter of a then uniquely low Fed Fund Rate of 1.25%.
The speech highlighted the challenges of a deflationary environment, and Bernanke offered prescient solutions regarding how the Federal Reserve could navigate a then still unthinkable environment despite a zero bound Fed Funds rate. These alternative solutions included lowering rates further out the term structure through purchases of longer-dated Treasury bonds, announcing explicit ceilings for yields, and operating in the mortgage-backed securities market.
Effect of Quantitative Easing
The first round of quantitative easing began in November 2008 when the Federal Reserve began purchasing agency mortgage backed securities. The close timing of the bottoming of the stock market in March 2009 (S&P 500 trough of 676 on 3/9) and the ramp-up of Treasury purchases by the Fed that same month is no doubt a factor in the market's ebullient attitude towards further quantitative easing. The second round of quantitative easing began anew in November 2010 when the Treasury announced they would being purchasing $600 billion of Treasury securities, paralleling another, albeit smaller rise in domestic stock prices. If stocks are valued based on a discounted future earnings or cash flow stream, then a lower discount rate should increase the present value of these businesses.
Marrying Fiscal and Monetary Policy
In a speech on February 10th to the National Association of Homebuilders in Orlando, Florida, Bernanke described the housing sector as a "key impediment to a faster recovery," and disfavorably compared today's economic recovery with past post-recession periods which saw a "resurgent housing sector fuel reemployment and rising incomes". Bernanke also gave some figures regarding the reduction of home equity's effect on consumer spending. At an estimated figure of $200 billion to $375 billion per year, this reduced spending equates to a GDP drag of 1.3% - 2.5%, the vast majority of the current marginal growth rate.
The head of the Federal Reserve described mortgage interest rates as a "key transmission channel of monetary policy." He bemoaned the inability of the banks his organization regulates to balance lending standards and appropriate deployment of capital to this tightened market. If the current Administration gets its way and expands the ability of homeowners to refinance via the Federal Housing Administration, perhaps quantitative easing in the form of continued purchases of agency mortgage-backed securities could help finance this policy objective.
Commentary from members of the FOMC on further quantitative easing has been mixed. In the minutes from the January meeting released on February 15th, it was stated that:
A few participants' assessments of appropriate monetary policy incorporated additional purchases of longer-term securities in 2012, and a number of participants indicated that they remained open to a consideration of additional asset purchases if the economic outlook deteriorated.
While only a minor change in syntax, it should be noted that the December minutes "a number" of members thought additional asset purchases were warranted, making "a few" a presumed decrease. The current composition of the board appears to make easing more likely given the recent overtures of Williams and Evans. The FOMC members that have campaigned most loudly against further accommodation (most notably Dallas President Fisher) are currently on the non-voting side of the Fed's rotation of votes amongst its twelve regional bank presidents.
Summarily, the dual mandate of the Federal Reserve dictates increased accommodation to support still troubling unemployment and underemployment levels especially given expected near-term disinflation. Bernanke, as a famed Great Depression scholar and someone who was conjecturing on how to deal with this particular crisis ten years in advance, is unlikely to err in pulling accommodation away from the economy too soon when inflation remains subdued.
The importance of re-starting our troubled housing sector could be aided by further quantitative easing in the Agency MBS market coupled with a prudent expansion of the eligible refinancing base (and perhaps even a little reflation) means we will likely see QE3 by the fall of 2012. When a multi-trillion dollar balance sheet re-enters the fray, markets will respond accordingly, and this should be positive for domestic rate, credit, and equity markets.