Federal Reserve Chairman Ben Bernanke's Congressional testimony should leave little doubt about the stance of monetary policymakers. Swift reactions came from Mark Thoma, Paul Krugman, Scott Sumner, and Joe Gagnon. Simply put, an incipient second half slowdown and fears of an outright double dip are insufficient to prod additional action on the part of the Federal Reserve. Policymakers are comfortable with the idea that neither objective of the dual mandate will be met in the foreseeable future. And even should the economy deteriorate such that they are forced into additional action, the likely policy candidates are woefully insufficient to meaningfully change the path of economic activity.
For all intents and purposes, the Fed is done. To be sure, the Fed would roll out its new set of lending facilities in response to another financial crisis. But setting the possibility of crisis aside, it is not clear what data flow short of a significant drop in activity would prompt a change of heart at the Fed.
Market participants set themselves up for disappointment. The set up began back with the Washington Post article suggesting that policymakers were actively considering the next set of policy options in light of recent data. I suggested the threshold for such actions was actually quite high, but the story fed upon itself until it became rumored that Bernanke would signal an end to providing interest on reserves. As Neil Irwin and Ryan Avent pointed out, the Fed Chair was simply not going to make a major policy announcement of that sort in Congressional testimony.
Worse, Bernanke did not appear overly concerned with the incipient second half slowdown. To be sure, he acknowledged the relatively weak data flow, but incoming information has only made the outlook "somewhat weaker," implying very little real shift in the fundamental view that the recovery is self-sustaining and sufficient to consume excess capacity over time and thus provides little reason to consider new policy options. Indeed, a substantive portion of the prepared remarks were devoted to tightening mechanisms, with the notion of additional easing left to the throwaway lines:
Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability.
Participants may also have been rattled by Bernanke's seemingly nonchalant attitude regarding additional easing options. From the Q&A:
SHELBY: Thank you.
Mr. Chairman, the minutes of the June FOMC, the Federal Open Markets Committee, meeting stated, and I'll quote, "The committee would need to consider whether further policy stimulus might become appropriate if the Outlook were to worsen appreciably," end quote.
Aside from taking the federal funds rate and the interest rate paid on reserves to zero, it's not clear to me what further policy stimulus would mean. If further stimulus were to involve more asset purchases that you alluded to by the Fed, would the Fed buy treasuries or would they try to channel credit to specific segments of the financial market, such as housing or perhaps even municipal debt?
BERNANKE: Senator, I think it's important to preface the answer by saying that monetary policy is currently very stimulative, as you, I'm sure, you're aware.
We have brought interest rates down close to zero. We have had a number of programs to stabilize financial markets. We have language which says that we plan to keep rates low for an extended period. And we have purchased more than $1 trillion in securities. So certainly, no one can accuse the Fed of not having been aggressive in trying to support the recovery.
You know, that being said, if the -- if the recovery seems to be faltering, then we would at least need to review our options, and we have not fully done that review, and we need to think about possibilities.
But broadly speaking, there are a number of things that we could consider and look at. One would be further changes or modifications of our language or our framework describing how we intend to change interest rates over time, giving more information about that. That's certainly one approach.
We could lower the interest rate we pay on reserves, which is currently one-fourth of 1 percent.
The third class of things, though, has to do with changes in our balance sheet, and that would involve either not letting securities runoff as they are currently running off, or even making additional purchases.
We have not come to the point where we can tell you precisely what -- what the leading options are. Clearly, each of these options has got drawbacks, potential costs. So we are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have, recognizing that, as I said, the policy is already quite stimulative.
The aforementioned Washington Post article suggested that plans for additional easing were pretty well fleshed out. A subsequent interview with Boston Fed President Eric Rosengren in the Wall Street Journal cemented that inference. Bernanke is much less clear: "…we have not fully done that review." Why have they not fully done that review? Because they are simply less concerned about a second half slowdown than most of the rest of the free world, instead considering the flow of data to simply be choppy, not worrisome. From New York Fed President William Dudley today:
“U.S. economic activity has expanded for four consecutive quarters, but at rates that can only be described as modest when compared with early stages of past recoveries,” he said. “The road to recovery is turning out to be a bit bumpy as relatively weak consumer spending and the ongoing problems in financial markets are keeping growth far less robust than we would like.”
Still, like Bernanke, Dudley views policy as quite stimulative. Why are Fed officials not willing to do more in the face of what is obviously suboptimal outcomes? First, consider the three options Bernanke lays out. The first two - committing to sustained low rates and cutting the interest on reserves - are not likely to have much impact. The implicit promise of low rates is likely already reflected in the short end of the yield curve. And while in a perfect world the Fed wouldn't charge interest on reserves, that last 25bp is likely not stifling much if any lending activity. Moreover, Bernanke appears to believe it is important to market functioning:
Each of those options carries drawbacks, he told a Senate committee Wednesday. Testifying before the House Financial Services Committee today, he elaborated on the risks of doing one of them: Lowering the interest rate it pays on excess reserves — now at 0.25% — could create trouble in money markets, he said.
“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.
“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”
In short, promising an extended period of low rates and ending interest on reserves would be minimally positive, but would not meet up with the expectations that would surround such moves. Indeed, the failure to meet expectations would be the real cost to the Federal Reserve. Taking these two off the table leaves expanding the balance sheet. Option 3a, not letting securities runoff, is more of an effort to maintain the status quo rather than provide additional stimulus. Again, I suspect relatively little impact. Which then brings you to Option 3b, purchase of additional securities - the only real option in my opinion. Optimally, the Fed would tie those purchases to some numerical target, such as Joe Gagnon's suggestion that the Fed purchases Treasury securities to target a 25bp target on the 3 year bond. You have to go out to three years to get some traction - at least there you have a whopping 90bps to play with.
Why will the Fed ignore Gagnon? Perhaps David Wessel has the answer:
Why wait? Put yourself in Mr. Bernanke's chair. When the Fed began buying mortgages, the gap between yields on mortgages and Treasurys was wide; now it isn't. Mortgage rates are very low and the housing sector is still moribund; it isn't clear pushing mortgage rates down another one-quarter percentage point would do much.
The Fed could buy more Treasurys, trying to push yields on 10-year Treasurys below the already low 3%. But that could backfire. With all the deficit angst around, a Fed move to buy Treasurys could provoke cries of "they're monetizing the debt" and push up long-term rates rather than lowering them.
As scary as this sounds, the Fed can't be sure of the net effect of buying more assets. It might not make things better. It would be, in short, a Hail Mary pass. And Mr. Bernanke isn't ready—yet—to throw it.
When it comes down to it, fear of the being seen as monetizing the debt will keep the Fed on the sidelines unless it becomes clear that the economy is actually trapped in a deflationary spiral. The bond vigilantes win again.
It is worth noting that the fear of high long-term rates is somewhat irrational. Wessel continues on with a discussion of inflation expectations:
Mr. Bernanke's former Princeton University colleague, Nobel laureate Paul Krugman, has become the loudest critic of Mr. Bernanke's inaction, calling the Fed "feckless" (lacking in vitality, unthinking, irresponsible) in his New York Times column. In a prescient 1998 paper about Japan, Mr. Krugman warned that other countries might similarly confront the feared "liquidity trap," the circumstance at which the central bank has cut interest rates to zero and the economy remains very weak. His advice then: "Monetary policy will be effective…if the central bank can credibly promise to be irresponsible"—by promising to create inflation in the future.
The textbook point: Interest rates that matter are the inflation-adjusted ones. In recessions, the Fed effectively pushes inflation-adjusted rates below zero. But with nominal interest rates at zero, the only way to get inflation-adjusted rates lower is to get everyone believing that inflation will go up.
So far so good. But then Wessel makes an odd detour:
The practical point: This is easier to advise than to do safely. It would, at the very least, be hard to explain to a public already suspicious of the Fed. And it, too, could backfire. Manipulating inflation expectations is hard to calibrate. And the move would mean higher nominal (though lower inflation-adjusted) long-term interest rates. And outside of economic textbooks, higher nominal rates can hurt, pinching cash-strapped households for instance. It's risky.
So economic textbooks are wrong? The nominal, not the real rate, of interest is the relevant variable? Was he sourced this view from the Fed? And would high nominal rates really pinch cash-strapped households? Perhaps we can think of an alternative view: Higher inflation expectations lifts wage growth, which in turn lowers the real cost of sustaining current debt loads and reduces the urge to reduce that debt via foregoing current consumption.
Rising long rates would indicate that policy is getting traction - that policy is actually stimulative. If there is no pressure for long rates to rise, then policy is not very stimulative. Fear of inflation and rising long nominal rates look sufficient to make policymakers accept a suboptimal outcome. Sad given that neither of these are an obvious problem now.
At the risk of making an already long post longer, I would point out a disturbing outcome of Scott Sumner's last two posts. In his review of the Bernanke testimony, Sumner opines:
The Fed has reduced its implicit inflation target below 2%, indeed below even 1.5%.
Marry that with Sumner's concerns about the Fed's pursuit of opportunistic disinflation. You quickly get to the conclusion that the Fed is not reacting to disinflation concerns because they are secretly happy, and have no intention of accelerating the healing of the labor market if that entails any risk the latest round of opportunistic disinflation is lost. So what the rest of us see as a failure to meet either of the dual mandates, the Fed really believes they are meeting the most important mandate, a strict definition of price stability.
Bottom Line: The Fed shows no sense of urgency with respect to the current economic situation, and appears prepared to endure a weaker second half with no policy shift. Moreover, even if the economy does worsen more than they expect, the likely candidates for policy action are more smoke than fire. The Fed knows this, and doesn't want to lose credibility on actions with little likelihood of success. A more aggressive policy stance Gagnon-style appears off the table as long as the Fed fears the possibility that such policy might actually work and push up long term rates. That means more significant action only after outright deflation expectations are evident. Appears extreme, but central bankers tend to be a conservative lot. Lacking a financial crisis, the need for more action is not apparent to them. They fundamentally believe they have done pretty much all that can be reasonably expected. Moreover, we need to reassess the Fed's inflation comfort level; they may think they are hitting one mandate just fine.