Tag Archives: forward guidance

(Revised) Can QE* Be an Effective Long Term Policy? Yes, and Here’s How.

The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE and forward guidance, or some alternate forms of these policies, be combined to create an effective long term policy?

Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy (hence the * in the title) being effective in the long term. Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier.

1.    Unconventional Monetary Policy Does NOT Cause Financial Instability

The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, and/or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’

Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:

unconventional MP_1

As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”

If the biggest argument against long-term use of QE (investors reaching for yield) is nullified, perhaps the Fed should think twice about continuing to taper. There is, however, the problem of surprising the market with such a change in policy. A possible solution to this is to continue the taper, but then start buying a constant level of bonds again after the taper is complete. If the Fed warns the public of such a long term policy change in advance, it could dampen the volatility the move would create in the markets.

2. Unconventional Monetary Policy Boosts Immediate Economic Growth and May Have Substantial Long-Term Growth Benefits As Well

The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.

Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of its validity.

So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:

unconventional MP_2

Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.

One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:

The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent.  Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.

If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.

In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.

Forward Guidance as Stabilizer

We all know that the Fed has been conducting an “unconventional” monetary policy since the end of the recession. The policy consists of bond-buying program and forward guidance program.  A familiar role that Fed’s forward guidance play is to insure investors and market that the Fed will be pursuing low interest rate policy during the period of time described in the guidance statement.

In this post I want to emphasize another role the forward guidance program take in the successful stable economic recovery. By being as transparent as possible about its ongoing monetary policy and future policy, through the forward guidance tool, the Fed officials try to give as much information as possible to market on the future moves in the monetary policy. Why the Fed has been doing this?

The answer relates to rational expectations. According to rational expectation model, economic outcome will depend on what agents, such as investors, firms, and consumers, expect to happen. By providing statements on the future unfolding of monetary policy, the Fed changes and strengthens market’s expectation about the monetary policy. Market then includes their expectations of monetary policy, which are partially created by the forward guidance, in their decision making. When the actual time of policy change comes, the market will react to it little or not at all depending on how their expectation was true. That means, a policy change, in this case, increasing federal funds rate, will receive a little reaction from the market at the time of the event since the market will have foreseen the coming of the policy change. In other words, the market will be considerably stable at the moment of the announcement.

Now, if the Fed hasn’t been pursuing the forward guidance policy for these years, there would have been a much greater monetary policy guessing game before every Fed meeting and more expectations would have been wrong in the absence of the forward guidance. As rational expectation theory would say, the agents whose expectations weren’t met by the policy change would have to make a change in their economic decision after the time of the event. That means there would have been greater stability in the financial market since the Fed’s raise of the interest rate started looking imminent.

In conclusion, the Fed has been stabilizing the markets since the end of the recession partially through its forward guidance program to give clear direction on the market’s expectation of monetary policy. Janet Yellen’s speeches following the Fed’s meeting in March have been to clarify the uncertainty created by the Fed’s meeting regarding the timing of the interest rate rise. That is what Yellen should be doing to ensure that market will not be surprised by the Fed’s move sometime in 2015 and react to it creating instability in the markets.

(Revised) Specific Forward Guidance to persuade the U.S. market participants

WSJ reporter Ben Leubsdorf summarized a recent speech given by the president of Federal Reserve Bank of Boston, Eric Rosengren. The original text of speech can be found here. In his speech, President Eric Rosengren claimed that Fed’s Forward Guidance should be more specific. If then, let’s compare two of most recent statements of Fed’s Forward Guidance.

During the Great Recession, FOMC had a fairly specific guidance such as “that short-term rates would remain low until we had seen significant improvement in labor market- improvement that could be proxied by seeing the unemployment rate fall to the 6.5 percent threshold” (Rosengren, p3). On the other hand, in March of 2014, FOMC adjusted their Forward Guidance as U.S. economy has picked up its pace and seen the report of which unemployment rate dropping down to 6.7% from 7.5%. Witnessing optimistic incoming data, Fed responded this with by cutting their bond purchase. At the March FOMC meeting, Fed suggested that “ for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent-run goal, and provided that longer-term inflation expectations remain well anchored” (Rosengren, p3).

Rosengren admits that recent announcement of Forward Guidance is bit less specific given that it is missing specific targeted goal, such as 6.5% unemployment rate in the previous example. In conjunction with pointing out the lack of specification in Fed’s Forward Guidance, WSJ reported Ben Leubsdorf named his article, Rosengren: Fed’s Forward Guidance Should be Linked to Employment, Inflation Data. However, the article is still somewhat missing the core message of what Rosengren had said in his speech. For example, Rosengren has emphasized that in order to achieve both sustainable employment and price level, “Forward Guidance should be increasingly focused on how quickly we expect to make progress on inflation “(Rosengren, p4). So it is not just about linking Forward Guidance to employment and inflation data.

In order to draw more positive attentions from the markets, Fed’s Forward Guidance should be specific but not overly specific to a level which Fed must not misguide the market by overlooking market uncertainties. Here is a good example of what is specific but not overly specific forward guidance. Rosengren suggests FOMC to “keep short-term interest rates at very low levels until the economy is within one year of reaching full employment and 2 percent inflation, based on the trends in incoming data and an assumption about how they will continue” (Rosengren, p5). By specifically hinting to market that Fed will follow the incoming data like summary of the economic projections (SEP) which has been routinely published by Federal Reserve Board members, Market watchers will become more prudent in analyzing the data which corresponds to the Fed’s Forward Guidance. I believe this will make the market more data oriented object rather than a rugby ball bouncing up and down with variety of unsorted uncertainties. In addition, benefit of having data orientated market that accords with Fed’s monetary policy can reduce the volatility of market risks compare to the absence of data oriented market. When Fed reduces the volatility of market sways, this will hugely benefit U.S. economy. One of the reasons, I think that Great Recession has not healed as quickly as Fed anticipated is that market’s own expectations were not necessary aligned with Fed’s expectations of market. For example, investors have their own expectations and have been playing their own expectation game.

In other words, there are too many boats searching for the same treasure, yet they bumped into each other and crashed, because they all have different beliefs even though the same map has been distributed to them. One possible reason that those boats are sailing their own ways and creating havoc during the course of the journey can be found in the lack of confidence of map that was given. In this analogy, map distributor is the Fed and sailors of boat are market participants.

Absence of complete information, how can we sail in a similar direction knowing that we may not find the treasure? Answer is: We have to make people to believe. How can Fed make them believe? How about borrowing a concept from the Ellsberg paradox? “The basic idea is that people overwhelmingly prefer taking on risk in situation where they know specific odds rather than an alternative risk scenario in which odds are completely ambiguous” What I am suggesting to Fed is that Fed should favor releasing more information that can help market participants to determine the risks of following what Fed announces. Then, markets will cautiously analyze the data, and will likely choose known risks rather than the odds that are unknown. Here, I am not encouraging the manipulation of data, but recommending a strategy which perhaps can align market expectations with Fed’s expectations of economy. Thus, it can stir more boats to sail in the same direction.

Revised: The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most unique policy tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance is merely a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so allows investors to understand when and how future interest rates will change, thereby reducing uncertainty and encouraging investment today.  This heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  At the onset of the lost decade in the 1990’s, the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, just a few years after the NASDAQ crashed, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy changes), the zero lower bound necessitates its use even today.  Because the Fed is unable to lower short-term interest rates to their necessary, negative value, it has no choice but to alter long-term rates in an effort to stimulate today’s economy.

While forward guidance seems to have been an effective (though painfully slow) policy tool in the last 6 years, recent debate has me worried about its legitimacy.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once a 6.5% unemployment rate is achieved, the Fed should raise interest rates per it’s promise.  However an intriguingly titled Wall Street Journal article caught my eye recently.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me worried that the Fed will not keep its promise to raise interest rates once 6.5% unemployment is achieved.

The article notes that some Fed doves are concerned about low levels of inflation.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated average inflation of 1.3% (uncertainty about the effects of Quantitative Easing has resulted in more conservative stimulus).  As shown in the graph below, this discrepancy in rates has caused a large discrepancy between predicted and actual price levels.  Many doves support the continuation of low interest rates (even after unemployment reaches 6.5%) so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

I have two concerns about continually low interest rates.  The first relates to the motivation for boosting inflation.  I certainly agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates.  However, once the Fed reaches its 6.5% unemployment target, its has achieved its goals.  Accordingly there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promise.

The issue of commitment brings me to my second and more important concern about continually low interest rates: failing to raise interest rates undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a useful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change once unemployment reaches 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) think like me, they will also lose trust in the Fed.  Should private investors lose trust in the Fed, forward guidance will be eliminated as a policy tool entirely, making economic stimulus at the zero lower bound extremely difficult.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the long-term strategy of central banks.  But today, this consensus simply does not exist, and there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, this type of debate will always exist.  And I think this debate should exist.  The Federal Reserve would be foolish to not reassess its long-term strategies given changes in the economic environment.  Like a successful business, an effective central bank should not commit to a single strategy, but rather should address each economic situation individually to respond optimally.

For this reason, I believe forward guidance, while powerful, is a foolish economic tool.  In order to preserve private investors’ trust, forward guidance locks the Fed into a single long-term strategy, inhibiting its ability to respond to unanticipated changes in economic conditions.  Unfortunately, given the zero lower bound, forward guidance has become necessary (as short term interest rates of 0% do not provide sufficient stimulus).  Therefore, in order to eliminate forward guidance as a policy tool, I believe addressing the zero lower bound should be a key priority of central banks.  So long as the zero lower bound exists and forward guidance remains necessary, the Fed cannot do its job as well as possible.

What does labor market slack look like?

In her remarks at the Economic Club of New York Wednesday, Janet Yellen focused on the things that the FED would be watching closely going forward.  The chairwoman made it clear she was more concerned with continued low prices then with inflation exceeding the 2% target set by the central bank. However, the FED’s primary focus remains on the labor market.  Fixing this market might take more then just monetary policy.

The Labor market has been characterized as having significant “slack” in it.  This term accurately describes the ability for businesses to add jobs with out having pulling up wages.  An increase in wages could cause inflation, so the FED is closely watching the labor market for signs of tightening.

What makes up this “slack”?  The Federal Reserve Bank of Atlanta publishes what is known as the Labor Market Spider Chart.  The chart provides a comparison of many labor market metrics at various times in one chart.  An image is shown below, but the link is interactive, so I encourage you to check it out.

Levels-Spider-Chart-from-the-Atlanta-Federal-Reserve-961x1024

This chart has a lot of information in it.  Most notably that there are a large amount of people working temporarily and part-time then would be in a healthy labor market.  There is also a dramatic decrease in marginally attached workers, are the discouraged workers who have worked or looked for work in the past year.  Given the other factors in this chart, some of this decrease may be due to workers giving up entirely and dropping out of the labor force, as opposed to actual hires, which are slightly worse then in 2012.

Janet Yellen would also mention that she believes that the economy can reach healthy levels in the employment market by 2016.  If the spider chart can be used to visualize labor market slack, then it can show tightening as well.  The Other parts of the circle need to shift out to their pre-recession levels as well.

There is a slight symmetry to the above graphs.  Hires on the right have to have some effect on job finding rate on the left.  Similarly with job openings and job availability.  Whether the FED alone can institute the policies needed to bring about the needed changes is unclear.  There is a lot of work to do.  The president of the Minneapolis Federal reserve bank, Narayana Kocherlakota has suggested certain fiscal polices that models suggest could result in the needed growth.  However, even if these policies where implemented, 2016 may be a very ambitious goal.

 

Building A Stronger Forward Guidance

WSJ reporter Ben Leubsdorf summarized a recent speech given by the president of Federal Reserve Bank of Boston, Eric Rosengren. The original text of speech can be found here. In his speech, President Eric Rosengren claimed that Forward Guidance should be more specific. Here is two different statements of Fed’s Forward Guidance.

During the Great Recession, FOMC had fairly specific guidance such as “that short-term rates would remain low until we had seen significant improvement in labor market- improvement that could be proxied by seeing the unemployment rate fall to the 6.5 percent threshold” (Rosengren, p3). On the other hand, in March of 2014, FOMC adjusted their Forward Guidance as U.S. economy picks up its pace and especially seeing unemployment rate dropping down to 6.7% form 7.5%. Witnessing optimistic incoming data, Fed responded this with by cutting their bond purchase. At the March FOMC meeting, Fed suggested that “ for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent-run goal, and provided that longer-term inflation expectations remain well anchored” (Rosengren, p3).

Rosengren admits that recent announcement of Forward Guidance is bit less specific given that it is missing specific targeted goal, such as 6.5% unemployment rate in the previous example. WSJ reported Ben Leubsdorf named his article, Rosengren: Fed’s Forward Guidance Should be Linked to Employment, Inflation Data, is somewhat missing the core message of what Rosengren had said in his speech. For example, Rosengren emphasizes that in order to achieve both sustainable employment and price level, “Forward Guidance should be increasingly focused on how quickly we expect to make progress on inflation “(Rosengren, p4). So it is not just about linking Forward Guidance to employment and inflation data.

In order to create a positive attention, Fed’s Forward Guidance should be specific but not overly specific to a level which Fed must be able to manage market’s uncertainties. For example, Rosengren suggests FOMC to “keep short-term interest rates at very low levels until the economy is within one year of reaching full employment and 2 percent inflation, based on the trends in incoming data and an assumption about how they will continue” (Rosengren, p5). By specifically hinting to market that Fed will follow the incoming data like summary of the economic projections (SEP) which has been routinely published by Federal Reserve Board members, Market watchers will become more prudent in analyzing the data which corresponds to the Fed’s Forward Guidance. I believe this will make the market more data oriented object rather than a rugby ball bouncing up and down with variety of unsorted uncertainties. In addition, benefit of having data orientated market that accords with Fed’s monetary policy can reduce the volatility of market risks compare to the absence of data oriented market. When Fed reduces the volatility of market sways, this will hugely benefit U.S. economy. One of the reasons, I think that Great Recession does not healed as quickly as Fed anticipated is that market’s own expectations were not necessary aligned with Fed’s expectations of market. For example, investors have their own expectations and have been playing their own expectation game.

In other words, there are too many boats searching for the same treasure, yet they bumped into each other and crashed, because they all have different beliefs even though the same map has been distributed to them. One possible reason that those boats are sailing their own ways and creating havoc during the course of the journey can be found in the lack of confidence of map that was given. In this analogy, map distributor is the Fed and sailors of boat are market participants.

Absence of complete information, how can we sail in a similar direction knowing that we may not find the treasure? Answer is: We have to make them believe. On way, I like to propose is by using the concept from the Ellsberg paradox. “The basic idea is that people overwhelmingly prefer taking on risk in situation where they know specific odds rather than an alternative risk scenario in which odds are completely ambiguous” What I am suggesting to Fed is that Fed should release more information that can help market participants to determine the risks of following Fed’s direction. Markets will cautiously analyze the data, and will likely choose known risks rather than the odds that are unknown. Here, I am not encouraging the manipulation of data, but recommending a strategy which perhaps can align market expectations with Fed’s expectations of economy. Thus, it stirs more boats to sail in the same direction.

Fed Officials Expect Overshooting Unemployment Rate

Following the Fed’s March 18-19 meeting, the policy making committee provided a collection of charts showing the projections of macro economic main variables in the coming years. Before discussing the projections, I should note here a little bit of confusion I have. In the projection file, it states that these projections are “based on FOMC participants’ individual assessments of appropriate monetary policy.” Therefore, these number’s aren’t actually projections as done by someone outside of the Fed, but these are the expected values of these economic variables that could be seen according to Fed officials’ own appropriate policy. 

In other words, when looking at these projections, we should take into consideration that these projections are influenced by each committee member’s policy recommendation.

The recent post on the WSJ touches on how this projection could be misleading the market into expecting that interest rate rise will come sooner than expected. According to the article, some Fed’s policy committee members raised their expectation of interest rates in 2015 and 2016. This could signal market that the Fed policy makers are looking at possible rate increase which is sooner than expected prior to March meeting.

ProjectionFed_March

 

From the above chart we could see what rate Fed officials are expecting fed funds rate target to be in 2014, 2015, 2016 and long-run. In 2014, according to the chart, we see that the policymakers almost unanimously expect the fed funds rate target be at the current level of 0 to 0.25 percent target. In 2015 and 2016, the averages of the Fed officials’ expected fed funds rate are around 1 percent and 2.5 percent, respectively. The policy makers expect the rate to be around 4 percent in the long-run. This rate is slightly lower than the historical average of the fed funds rate target since 1990, which is 4.2 percent. In general, the committee members expect to have similar fed funds rate target that it has had since 1990.

Note that, the expected fed funds rate target is still lower than long-run expected rate of 4 percent at around 2.5 percent in 2016. Hence, it is plausible that somewhat easy monetary policy will be taking place until 2016. But we should always remember that low interest rate doesn’t always mean expansionary monetary policy as Milton Friedman put it, “After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

The surprise of the projection comes when we look at another chart which was included in the same projection report. The following chart shows how the committee members expect the unemployment rate to be under appropriate policy in coming years and in the long-run.

ProjectionFed_MarchUn

 

The central tendency among the policy makers regarding the expected unemployment rate in 2016 is along with the long-run projection: at 5.2-5.6 percent.

So, what can we conclude about the Fed’s future policy from these two charts?

The Fed policy makers are believing (or seems to be) that under appropriate policy, the Fed will be pursuing expansionary policy even after the unemployment rate reaches the long-waited long-run average. In other words, the Fed policy makers think overshooting the unemployment rate is a viable option for the Fed policy in coming years. This is along the line with the worry about low inflation in coming years. Another chart in the projection shows how the policy makers expect inflation to be in coming years.FedINflation

 

As we see from the chart that central tendency among the officials regarding the expected inflation in 2016 is below the Fed’s target of 2 percent inflation. It is kinda counter-intuitive; they target 2 percent, but expect it to be below it. Or are they really targeting 2 percent?

Then, given the the below target inflation rate, the Fed officials shouldn’t be worried about their fed funds rate target expectation below the long-run expectation.

From the Fed officials’ projection, we can conclude that the Fed will be still operating somewhat stimulus policy in 2016 relative to their long-run policy.– if we assume these projections are made with rational expectation

Yellen Attempts to Control Expectations

Interest rates rose following the March Federal Open Market Committee (FOMC) meeting in which the Fed eliminated the quantitate thresholds for unemployment and inflation from forward guidance. Without these thresholds, financial markets were left in perplexing uncertainty regarding the timing of interest rate hikes. Particularly, markets speculated as to when rates would rise once the Fed completed tapering its asset purchases. Although the FOMC statement provided an extremely vague time period, Yellen seemed to define the time period to be precisely six months in the post-FOMC press conference.

Unfortunately, financial markets misinterpreted Yellen’s words to be more exact than she intended. Prior to the March FOMC meeting, expectations for a first rate hike were in late 2015 or early 2016. According to the Wall Street Journal, “Some investors had taken Ms. Yellen’s remarks at a news conference after that [FOMC] meeting to mean rate increases might come sooner than they expected”. After the March FOMC meeting, yields on the two-year and five-year treasury adjusted to price in a rate hike around mid-2015 (i.e. about 6 months following the projected conclusion of the Fed’s tapering).

fredgraph2yrTreasuries fredgraph5yrtreasuries

As seen above, the two-year treasury yields had their largest single-day move since 2011 and the five-year treasury yields had their largest single-day move since September 2013 and rose the most since June 2013. The two-year and five-year treasury yields rose to reflect changes in expectations about the future.

In a speech on Monday, Yellen attempted to diminish these expectations to stop yields from moving higher. Yellen offered five reasons why she still sees slack in the economy. First, the number of involuntary part-time workers remains elevated. Second, statistics on job turnover is very low. According to the Wall Street Journal, “[Low job turnover] is an indicator that people are reluctant to risk leaving their jobs because they worry that it will be hard to find another”. Third, wage growth since the financial crisis has been low by historical standards. Fourth, a significant portion of the unemployed has been out of work for six months ore more. According to the Wall Street Journal, “The concern is that the long-term unemployed may remain on the sidelines, ultimately dropping out of the workforce”. Fifth, the proportion of working-age adults that hold or are seeking jobs (participation rate) has continued declining since the recession and throughout the recovery. Yellen believes these signs of slack in the economy give the Fed room to keep interest rates low.

Yellen also attempted to reshape the perspective on tapering. According to the Wall Street Journal, “She emphasized that the Fed’s recent decisions to reduce the size of its bond-buying program, meant to keep long-term interest rates low to spur growth, shouldn’t be viewed as a withdrawal of support of the economy. Rather, she said the Fed is adding support at a lower pace”. Although some might view the tapering of asset purchases as a withdrawal of stimulus, Yellen prefers the perspective that it is only a decrease in the rate by which stimulus is growing. Furthermore, monthly asset purchases themselves do not stimulate the economy. Instead, the size and duration of the Fed’s balance sheet (i.e. balance sheet monetary policy), which the Fed will maintain even after it stops expanding, will continue to stimulate the economy. As a result, financial markets should not be concerned that the Fed’s tapering is representative of tightening monetary policy.

Despite Yellen’s dovish message, treasury yields have not fallen to their pre-FOMC meeting level. I am not surprised by this because treasury yields were quite low before and are now adequately pricing interest rate risk. Although interest rates might not rise in early 2015, I think rates will start rising by late 2015 and this is reflected in the current level of the two-year and five-year treasury yield.

Fed, Raise the Inflation Target

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”. In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed’s target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman’s inflation target of somewhere around 4 percent. We can see an evidence for the Fed being hawkish.

In the Fed’s recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed’s former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.

The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed’s statement still includes the inflation target of 2 percent. The Fed’s latest statement reads:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Let’s now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:

First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won’t have to do either of above.

In other words, from the Fed’s current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.

Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.

Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).