A current acute awareness of forecast bias leaves me almost hesitant to comment on Friday's speech by Federal Reserve Chairman Ben Bernanke.
What is forecast bias? Here I am thinking of the bias of Fed watchers struggling to interpret every bit of data and every comment from policymakers in the context of their own views of the economy. One version of such bias is thinking the Federal Reserve will do what you think they should do. Because you view the economy as weak, you assume the Fed will do so as well, and react appropriately. Such a bias, of course, will lead to an erroneous interpretation of the data and Fedspeak as it relates to monetary policy.
I fear falling into a variation of this bias. For months, the flow of data and the Federal Reserve's own forecasts indicate the Fed will continue to fall short of both its employment and price stability mandates. This has been confirmed by numerous Fed speakers including Bernanke himself. Indeed, Bernanke has often stated disappointment with the pace of the recovery and, in particular, the costs of high levels of long-term unemployment. He has also said that nontraditional policy tools continue to be effective, indicating that the Fed could do more to boost the recovery.
Yet such action has been fairly limited. I tend to see the extension of Operation Twist as simply maintaining the status quo, not additional easing. Expectations for another round of quantitative easing have been disappointed for the last three meetings. The bar to additional action has simply been higher than many believed.
So now I ask myself if monetary inaction during 2012 leads me to place a "no action" bias in my own analysis. Am I picking out what I want to hear, and ignoring what I don't?
Now, in all honesty, I haven't had a strong conviction on the last two meetings. They seemed like relatively close calls. On average, though, the Fed has moved gradually toward another round of quantitative easing, with seemingly only Bernanke holding back policymakers.
Has Bernanke finally flipped sides, reverting to the Bernanke that we thought we knew back when he was writing about Japan? That is the question we ask as we take apart his Jackson Hole speech. And what biases are we bringing to the table when we do that analysis?
My first take on the speech was that Bernanke largely rehashed what I think was general knowledge, although with a somewhat dovish spin that would indicate a higher probability of quantitative easing at the next meeting than I had previously believed. No obvious signs, but certainly on the margin pointing to additional easing. And whenever I worry about my bias, I seek confirmation from the bond markets. Right now, yields are down 4 to 5 bp, which is what I think would be the expected market reaction from a slightly more dovish Bernanke. So far so good.
Bernanke's speech is largely backward looking. He examines the effects of nontraditional tools, both balance sheet tools and communication strategies, and concludes that both have been effective in easing financial conditions and boosting economic activity and employment. This result should really come as no surprise; Bernanke had previously expressed confidence that nontraditional tools had positive policy impacts. And he is not going to reverse course now and say that policy has been a failure.
More important is his subsequent cost/benefit analysis. For months, we have been able to surmise that Bernanke believed the costs of additional action outweighed the benefits. If this wasn't the case, he would have eased already. Is Bernanke's analysis shifting?
Bernanke lists four potential costs: Impaired functioning of securities market, heightened inflation expectations, risks to financial stability from encouraging excessive leverage, and potential losses to the Fed's balances sheets. He quickly dismisses every concern, leading one to conclude that another round of QE is a no-brainer as the benefits obviously exceed the costs. He concludes the section with:
In sum, both the benefits and costs of nontraditional monetary policies are uncertain; in all likelihood, they will also vary over time, depending on factors such as the state of the economy and financial markets and the extent of prior Federal Reserve asset purchases. Moreover, nontraditional policies have potential costs that may be less relevant for traditional policies. For these reasons, the hurdle for using nontraditional policies should be higher than for traditional policies. At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.
Now I hesitate - is this really a no-brainer? Do "economic conditions warrant" additional action? And notice that the cost/benefit analysis varies over time. While the benefits clearly outweighed the costs during the height of the crisis, is that still true today?
Bernanke then assesses the current economy. He is clearly not happy with the current state of affairs:
Notwithstanding these positive signs, the economic situation is obviously far from satisfactory.
Specifically, he identifies persistent high rates of unemployment, and dismisses a structural explanation. Thus, with the problem being cyclical, we have a clear role for monetary policy. This seems to "warrant" additional action. But what is the explanation for persistent high unemployment rates?
...First, although the housing sector has shown signs of improvement, housing activity remains at low levels and is contributing much less to the recovery than would normally be expected at this stage of the cycle.
Second, fiscal policy, at both the federal and state and local levels, has become an important headwind for the pace of economic growth... It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery.
Third, stresses in credit and financial markets continue to restrain the economy. Earlier in the recovery, limited credit availability was an important factor holding back growth, and tight borrowing conditions for some potential home buyers and small businesses remain a problem today. More recently, however, a major source of financial strains has been uncertainty about developments in Europe...
Now I am concerned again, as Bernanke appears to be saying that the factors currently restraining the economy cannot be addressed by monetary policy. So what are the benefits to additional nontraditional tools in the current environment? Is he kicking the can back to Congress? Indeed, he later says:
In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.
This does not sound like he believes additional monetary policy would be particularly effective in the "present context." But he follows with this:
As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.
So now I am thinking he has focused his comments almost exclusively on the employment portion of the mandate, not the price stability part (which they aren't hitting anyway, but that is a different story). This alone should scream additional easing. But is Bernanke really hinting at a bias toward additional easing, or is he simply trying to convince everyone that he really cares about unemployment, even though he has not acted more aggressively to date? He cares, but just can't do much about it? Or is that just my internal bias speaking, the bias from months of the Fed seeming to say one thing while doing another?
Attempting to take my own bias into account, my takeaways are:
Bernanke gives a very clear defense of nontraditional monetary tools to date. The benefits have clearly outweighed the costs. His rapid dismissal of the potential costs leads one to believe that he is more inclined than not to additional action. This is critical; he is the key to moving the middle ground to additional easing.
That said, the analysis is clearly backward looking. Do current conditions imply the same cost/benefit analysis, which Bernanke clearly states varies over time?
Bernanke expresses considerable concern about high levels of unemployment. But he also seems to say that the factors preventing more rapid labor market improvement are beyond the scope of monetary policy. This sounds like Bernanke is not confident that more monetary policy will be effective.
Taken together, Bernanke is attempting to be a man for all seasons, giving a spirited defense of the past that clears the way for additional action, while explaining why such action might not be effective or taken in the future. Felix Salmon sums it up with:
The overall tone here, then, is defensive: Bernanke's on the back foot, trying to justify past and future actions against critics on all sides. And when an institution is in a defensive crouch, it's not going to do anything bold. The Fed was bold in 2008-9, at the height of the financial crisis; those days are over now. And so, whether we like it or not, any real boost for the economy going forwards is not going to come from the Fed, and is going to end up having to come from Congress instead. I'm not holding my breath.
Yes, if Bernanke is leaving it up to Congress, we have some troubling days ahead.
Bottom Line: On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed. His defense of nontraditional action to date and focus on unemployment point in that direction. This is the bandwagon the financial press will jump on. Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture. This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.