The end of Quantitative Easing?

Over at Business Insider we find that Wall Street Journal reporter John Hilsenrath, who seems to be so well-connected to the Fed that it has earned him the nickname “Fed Wire”, has apparently been told that the Fed is discussing the end of its quantitative easing program. As he writes, the “focus is on managing unpredictable market expectations”. In his words, “officials say they plan to reduce the amount of bonds they buy in careful and potentially halting steps, varying their purchases as their confidence about the job market and inflation evolves. The timing on when to start is still being debated.”  None of that makes any sense at all. But first things first.

Back in December 2012 the Fed decided to adopt what is generally referred to as an Evan’s Rule, named after Charles Evans, the head of the Federal Reserve Bank of Chicago. The main idea is to signal to the market a clear commitment of providing easy money until some chosen economic indicators fall below (or rise above) a particular threshold value. In particular, the Fed announced it will keep short-term interest rates near zero until either unemployment drops below 6.5% or inflation rises above 2.5%. All this is part of an attempt to include “forward guidance” concepts, a favorite new term of central bankers and monetary economists, into policy making. The point is that there is no “timing” to be debated. The Fed has told us when it will change course: once one of those two goals is achieved. Before that happens, you keep the pedal to the metal (even though current monetary policy falls short of even that, but we’ll leave that for now). The chart below the fold shows that both those indicators are still quite a bit off their marks.

Core inflation, meaning CPI excluding food and energy prices (the measure central banks should and in the case of the Fed indeed do look at), shown in blue and on the left axis, has not reached 2.5% in the past 4 years, and has even started to decline again in the past year. Unemployment, in red and on the right axis, is at least moving in the right direction but is still a full percentage point off target. And what does “the focus is on managing unpredictable market expectations” even mean? The only thing unpredictable about Fed policy in recent months has been how predictable it has become. And that was the whole point of the exercise! Why should the market suddenly expect anything else? Sure, there are questions regarding how the central bank will go about unwinding its quantitative easing program, but until that starts there should be no doubts at all about how the Fed’s monetary policy is going to change, because it isn’t and shouldn’t. Unless the FED plans to end QE3 before the not overly ambitious targets of the Evan’s rule are achieved, which I would argue would be terrible policy.

The article linked to above concludes by stating that “it seems the big moment is finally upon us. The Fed is finally serious enough about starting its “exit” that it is telling Wall Street to get ready”. As far as I can tell, it told Wall Street all it needed to know about its actions going forward back in December. How is this news? And does the market seriously need this kind of hand-holding in order to prevent financial Armageddon from happening? If it does, we’re in even deeper trouble than we had thought.

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4 thoughts on “The end of Quantitative Easing?

  1. Do you want people to comment? Because I wholeheartedly disagree with most of what you’ve just written, but maybe you’d prefer to get my comments via email?

  2. Nice.
    So, off the top of my head, some points I’d like to make:
    (1) Well, first of all this is not an official FED statement yet, but some guy who says that the FED might be discussing exit strategies – something they’ve hopefully been doing for a while. So, I agree, I wouldn’t call this “news”, but on the other hand I do think that you need to update the market on what you are doing. If you approach your goals you have to repeat and clarify what your next steps are. You need to manage expectations and if that means repeating what you already said, then you should, because that’s one big component of monetary policy. Why? –>

    (2) >And what does “the focus is on managing unpredictable market expectations” even mean?<
    It means that they'd rather prevent events like this one http://en.wikipedia.org/wiki/Black_Monday_(1987) If there is one thing we've learned then it is that the market is not rational and herd behaviour forms quickly. There's probably nothing more crucial than transparency and certainty about future monetary policy in the current situation.

    Regarding the Evan's rule (interesting point, btw):
    (3) What I am wondering is: After we just had a financial crises that was partly caused by monetary policy that was overly focused on core inflation and ignored asset prices and consumer credit growth, maybe we should look at other indicators rather than core inflation to time our exit strategy. And I truly hope that the FED does and if it is appropriate given those indicators to exit before you reach a 2,5% inflation target, then you maybe should do that. The last thing we want is getting out of the crisis to jump into the next unsustainable expansion.

    (4) Are we all worried about what happens if you cease to provide easy money too early? Sure. But at the same time: Can you really cure an economy suffering from a crisis caused by "easy money" by injecting more and more liquidity? Unless serious structural adjustment happens, we are doomed anyway. At the moment it seems to me (I'm still trying to figure out some things here, so take it as a momentary opinion) that we are sitting on a time bomb and the only thing that keeps it from exploding is easy money. Thus I see a certain tradeoff: we are obviously unable to structurally adjust WHILE we are muddling through with easy money, but we are afraid of those (most likely very costly) adjustments we dearly need. (and I'm NOT saying I want to replicate the Great Depression) I'm therefore not quite sure which one is the "terrible policy" choice.

    Sorry, I'm very bad at keeping it short and simple.

  3. Thanks for the notes. Some quick thoughts.
    (1) True, it’s not an official statement by the FED, but it appears this is sort of the way the FED has channeled news to the market in recent times. Basically the monetary policy equivalence of a “floating a trial balloon”. Stuff they seem to want to get out, but can’t just yet do through official channels. I agree completely with the rest of that statement, and admit to sometimes trying to write a bit provocatively to get a response. It worked 🙂

    (2) I don’t know much about that crash, but am unable to find out how it had much to do with monetary policy. And yes, ever since the Fed reached the zero lower bound, transparency has been sorely lacking. Mostly because no one really really knew what to do next, so no one could tell you what was going to happen next, I assume.

    (3) I could not agree more. I’m actually writing a seminar thesis on the topic of whether central banks should target asset prices as well, fascinating stuff. Australia and Sweden have raised interest rates in the past and cited housing prices as a reason.

    (4) In my opinion the idea that the crisis was caused by “easy money” is one of the biggest misconceptions out there. I will probably do a post going into the details later this week if I get to it. Bernanke (and the Fed in general, even though there might be incentives for them to dispute it) has done some useful research and come to the result that the effects of monetary policy on asset prices in creating the housing boom, and don’t find much. Taylor is often cited as showing using his rule that money was too easy, but using many of the other “rules” out there, this starts to seem a bit more questionable. I feel stable NGDP growth is a better indicator to begin with, and until the crisis started (meaning up to almost 2008), the Fed seems to have been remarkably successful at achieving this. The housing bubble burst in 2006, the big crisis didn’t start until almost 2008. Sure, there are lags involved here, but the interesting thing is that the major crisis only began once the Fed let NGDP growth to collapse. And Friedman back in 1968 already recognized that low interest rates are generally a sign that money has been tight, not that money has been easy.

    I guess we both have the same problem with short and simple…

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