Stephen Lewis, Chief Economist, Monument Securities
At his press conference yesterday following the FOMC meeting, Mr Bernanke was intent on pointing out that monetary policy is no panacea. This has been his constant refrain recently, a plea for clemency perhaps in any judgment of the Federal Reserve’s limited success in meeting the terms of its mandate. Yet, the Bernanke-led Fed continues to act as though it still believes monetary policy alone can turn round the US economy and restore it to full employment. That is the logic of the FOMC’s decision, should the labour market not improve substantially, to ‘continue its purchases of agency mortgage-backed securities (MBS), undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in the context of price stability’. This statement presupposes that Fed asset purchases will eventually bring about the desired strengthening in the labour market. The FOMC does not countenance a situation where the Fed might continue its asset purchases until the cows come home, without achieving the substantial improvement in labour market conditions that it seeks. Yet, this is a scenario that those who monitor the Fed’s actions increasingly regard as plausible, if not probable. Mr Bernanke, it seems, is loath to abandon the conviction, most clearly expressed in his famous speech of November 2002, that a central bank always has the means to boost the economy. There was no talk back then of monetary policy not being a panacea.
The FOMC is now focusing on one half of its dual mandate, as it aims to maximise employment. Its statement pays lip-service to the other half of the mandate in the phrase it appends, ‘in the context of price stability’. We do not know how seriously FOMC members take the threat that they might have to terminate the Fed’s asset-buying before the employment objective has been reached, on account of a troublesome rise in the inflation rate. Internal evidence suggests most of them do not take this risk seriously at all. The ‘central tendency’ of FOMC policymakers’ projections for core PCE inflation foresees it in a range of 1.7-1.9% in the year to 2012Q4, 1.7-2.0% to 2013Q4 and 1.8-2.0% to 2014Q4. Though these rates are marginally higher than the previous FOMC projections published in June, they are all in line with Fed policymakers’ notion of what constitutes price stability, perhaps suspiciously so to some observers. After all, for both 2014 and 2015 the ‘central tendencies’ for real GDP growth are now 3.0-3.8%. That is way above the longer-run ‘central tendency’ of 2.3-2.5%, which represents the FOMC’s idea of trend GDP growth. It seems unlikely there would not be some upward pressure on the inflation rate, if only reflecting bottlenecks in supply, should the economy grow as FOMC members say they believe it will. The question then would be how the FOMC might react to the rise in inflation. It might be prepared to overlook it for a while. That could not help but create uncertainty about Fed policy. Probably, FOMC members do not really expect inflation to rise to a level where it might become a challenge for policymakers. But that would only appear a tenable position if they really did not believe economic growth would be as strong as they say, that is, if they really believed that the Fed’s asset purchases would fail to bring substantial improvement in economic demand. Mr Bernanke has sought to relate Fed commitments to economic objectives because he believes this improves the transparency and certainty of Fed communications. But, as this example shows, the FOMC statement on Fed asset purchases, if taken at all seriously, leaves markets in a state of uncertainty as to how the Fed will conduct policy.
In fact, the markets are not at all uncertain about Fed policy. This is because they are not taking seriously the phrase in the FOMC statement relating to price stability. They are probably right to interpret Fed policy in this way. Mr Bernanke at his press conference evinced no concern for inflation, while dwelling on the challenge facing the Fed in bringing down unemployment. He is acting as though the Fed has a single mandate, to cut the jobless queues, and is ready to subordinate all else to that goal. MBS prices responded positively to yesterday’s statement and the comments from the Fed Chairman. Longer-dated Treasuries prices fell sharply, however. The weakness in long-dated Treasuries may partly have reflected disappointment that the Fed is not to step up its purchases of these assets immediately. But it could have reflected also investors’ concern that the Fed’s strategy had shifted from pursuit of the dual mandate, which previously had limited its actions to undertaking operations of a definite size on a pre-determined time-scale, to what is effectively a single employment mandate allowing open-ended operations. The fillip to the MBS market may be helpful in supporting the housing sector. If the Fed is aiming to exert general downward pressure on long-term interest rates, though, it is important it should note that Treasuries, not MBS, serve as the benchmarks for rates in other asset markets. If, as a result of the FOMC’s latest decision, confidence in Treasuries is eroded, yields on other assets are also likely to rise. The Fed’s policy will then be counter-productive.
There is another problem in assuming that the Fed will go on buying assets until economic recovery is so well entrenched that a substantial fall in unemployment is assured, as Mr Bernanke is promising. This is that Mr Bernanke’s position at the Fed is now insecure. His current term as Fed Chairman expires in January 2014. Mr Romney has indicated since the latest FOMC meeting that, were he in the White House at that time, he would not reappoint the incumbent. Mr Romney and Mr Obama are running neck-and-neck in opinion polls, with Mr Romney, if anything, strengthening has standing in recent days. At this stage, all that can be said is that the Fed’s latest ‘open-ended’ pledge is good until the beginning of 2014. In the weeks ahead, the opinion polls are likely to be the decisive influence on market perceptions of future monetary policy.