Communication and Normalizing Fed Policy
When the Federal Reserve last neared a period where removal of accommodation was to be the intent of monetary policy actions, the concept of normalization had a singular reference – the level of support provided. Normalization from a period of excess accommodation required the Fed simply to increase the Fed Funds rate. Today, economic support is provided by the Fed in the form of extraordinary accommodative monetary policies. These policies are extraordinary as much in their abundance as in the method of operation. In Fed Chair Yellen’s view, normalizing monetary policy today involves two separate goals - adjustment to the stance or level of accommodation provided and also a return to prior methodology of operations.
Before proceeding with a brief discussion about communication and normalizing monetary policy, we might quickly dispense with a view of the prospects for immediate outcome from the forthcoming FOMC meeting. First, the Fed has done a wonderful job of adhering to a ‘policy-path’ for reducing securities purchases (tapering). It is expected to again reduce by a total of $10b, the level of agency mortgage-backed securities and Treasuries purchased monthly to new levels of $10b and $15b respectively. In the statement, the Fed may recognize a somewhat stronger pace of economic growth and employment gains since the last meeting, but would then also likely reference the mixed performance of the housing market. Finally, the forward guidance on Fed Funds will likely not be changed. At some point, the Fed will introduce additional guidance both for policy rate and the balance sheet, but it is not expected at this meeting.
Normal is as Normal Does
Dr. Janet Yellen was charged in 2010 by then Chairman Bernanke to lead a FOMC subcommittee on communications. As such, we might look to her assessments described in an April 2013 speech ‘Communication in Monetary Policy’1 to better understand her interests for the direction for monetary policy communications and implications for operations. In doing so, I think you will agree that Chair Yellen has indicated a desire to return monetary policy operations toward a more ‘old school’ Fed Funds based approach. At the same time, she has a strong belief in the benefit of guidance.
While it is difficult to imagine any striking change to the message immediately following this meeting, the Chair recognizes the importance of the post-FOMC statement; ‘The Committee's most watched piece of communication is the written statement issued after each of its meetings, which are held roughly every six weeks. It may seem quaint that my colleagues and I continue to spend many hours laboring over the few hundred words in this statement, which are then extensively analyzed only minutes after their release.’ In general we understand that if there is a nuanced shift in describing something in the FOMC statement, it is not likely a mistake but rather an attempt to reshape consensus view.
There were several instances within this speech where Dr. Yellen made reference to ‘normal’ monetary policy and an interest in returning to such. In referencing a long road to recovery she noted; ‘I am encouraged by recent signs that the economy is improving and healing from the trauma of the crisis, and I expect that, at some point, the FOMC will return to a more normal approach to monetary policy.’
Having recognized the amazing advances in pace for all measures of public communication, she advised; ‘The revolution in the FOMC's communication, however, isn't about technology or speed. It's a revolution in our understanding of how communication can influence the effectiveness of monetary policy.’ It is apparent that the Fed under Janet Yellen will go to great lengths to achieve higher levels of monetary policy effectiveness through communication.
Again and again she points toward a normal monetary policy in; ‘In normal times, the Committee pursues these goals (to promote maximum employment and stable prices) by influencing the level of a short-term interest rate called the federal funds rate, which is what banks charge each other for overnight loans.’ Her desire to return to a Fed Funds based regime is quite evident.
Throughout the speech, then Vice Chair Yellen tells the story of the evolution of Fed communication to include the 2003 reference to ‘policy accommodation can be maintained for a considerable period’; ‘The FOMC had journeyed from "never explain" to a point where sometimes the explanation is the policy.‘
While appearing to make a point about the potential difference in the support provided by securities purchases relative to the communication about their holding periods, Yellen made strong argument for providing accommodation through the discussion of SOMA asset disposition; ‘To make these asset purchases as effective as possible in adding accommodation, the FOMC, therefore, needs to communicate the intended path of Federal Reserve securities holdings years into the future.’ Using this as a guide, the Fed has provided some accommodation during the well articulated ‘policy path’ of tapering. We should expect the Fed to do similarly with respect to its securities holdings going forward. Yellen added again later; ‘While normalization of the Federal Reserve's portfolio is still well in the future, the FOMC is committed to clear communication about the likely path of the balance sheet.’
The longing for good-old fed fund policy can again be found in; ‘Getting back to more normal economic conditions will allow for a more normal approach to monetary policy. I look forward to the day when we can put away our unconventional tools and return to what now seems like the relatively straightforward challenge of setting the federal funds rate.’
In wrapping up her speech Yellen finished noting; ‘Communication became even more significant after the onset of the financial crisis when the FOMC turned to unconventional policy tools that relied heavily on communication. Better times and a transition away from unconventional policies may make monetary policy less reliant on communication.’ It is true that less communication is needed in better times. It is likely also true that too much communication or more specifically, excessive guidance during a ‘restrictive’ monetary policy regime, can offset the intended effect of policy rate firming. This apparently was the case in 2004-2006 when the Fed used the ‘measured pace’ guidance.
Fed Discusses Exit Strategy
The FOMC weighed in on exit strategy in the minutes from the June 17-18, 2014 meeting. Titled ‘Monetary Policy Normalization’2, the section accounted for roughly 15% of the entire lengthy outline of the meeting. It was noted immediately that the discussion about ‘normality’ is not only of the stance of monetary policy, but also about operational conduct; ‘Meeting participants continued their discussion of issues associated with the eventual normalization of the stance and conduct of monetary policy.’
The minutes caught many by surprise having indicated that interest on excess reserves (IOER) would play a major role in normalizing the policy rate stance; ‘Most participants agreed that adjustments in the rate of interest on excess reserves (IOER) should play a central role during the normalization process. It was generally agreed that an ON RRP facility with an interest rate set below the IOER rate could play a useful supporting role by helping to firm the floor under money market interest rates.’ Prior to the minutes release, it is probably fair to say that a majority of those with a view thought that ON RRP would be doing the heavy lifting. It may be that in practice that ON RRP does the lion’s share of work, but the Fed may find communication involving IOER as more easily understood by the public, and lending eventually to an smoother transition to ‘old school’ or ‘normal’ policy operations.
Clearly communication as a policy instrument is given a high degree of importance when we find strategies are devised for its application; ‘A staff presentation included some possible strategies for implementing and communicating monetary policy during a period when the Federal Reserve will have a very large balance sheet.’
Quite possibly more for its familiarity as a benchmark and ease of use in communicating policy intent than as a strong instrument for implementation of policy, most FOMC members want to keep fed funds in the mix; ‘Most participants thought that the federal funds rate should continue to play a role in the Committee's operating framework and communications during normalization, with many of them indicating a preference for continuing to announce a target range.’ If there is a strong interest for eventually removing much of the Fed’s balance sheet and moving back to an operation based on targeting fed funds, it would be a communication nightmare to allow fed funds to disappear while the balance sheet is reduced only to try to introduce it again thereafter.
Concerning changes to the reinvestment policy, it was noted that the timing of the elimination of reinvestments would have very ‘limited implications for macroeconomic outcomes’. However, the Fed may choose to use the upcoming event as a forum for communication enhancement. Although the macroeconomic implications of the timing of the change may be miniscule, a benefit could be derived from communicating its removal. Not unlike the benefit from describing the ‘policy path’ for tapering, properly communicating changes to the reinvestment policy can add ‘visibility’ to the Fed’s transparency thus providing some support during instances of accommodation removal.
Consistent with earlier noted preference for policy path, FOMC members noted; ‘Regardless of whether they preferred to introduce a change to the Committee's reinvestment policy before or after the initial tightening in short-term interest rates, a number of participants thought that it might be best to follow a graduated approach with respect to winding down reinvestments or to manage reinvestments in a manner that would smooth the decline in the balance sheet.’ This too has the sound of ‘policy path’ guidance.
Although, ‘participants generally expressed a preference for a simple and clear approach to normalization that would facilitate communication to the public and enhance the credibility of monetary policy’, this may be more difficult than in the past as they have admitted ‘they expected to learn more about the effects of the Committee's various policy tools as normalization proceeds’. Because they have much to learn, ‘many favored maintaining flexibility about the evolution of the normalization process as well as the Committee's longer-run operating framework.’ Here in lies a challenge for the Fed. Even though more open communication is desired, the flexibility required to wind down current extraordinary accommodation may not allow simple and long lasting policy directive.
Chair Yellen and the balance of the FOMC committee would like, when the time comes, to remove accommodation in a straight forward and easily communicated fashion. They may attempt to highlight fed funds for the benefit of public understanding and a hoped for eventual return to prior standard operating procedures. However, their challenge in communicating policy intent may be easier than detailing over a longer period what tools will be used to accomplish those ends. To the extent economic agents have become accustomed to knowing with relative certainty an exaggerated period of forthcoming monetary policy intent, there is a decided likelihood that volatility in both economic variables and performance could increase.
Therefore we should anticipate that wherever possible the Fed will engineer ways to provide some guidance in the use of policy tools. Consistent with the reduction of the pace of securities purchases (tapering) where the Fed gave ample information before the initiation as to a likely discrete interval value changes, the Fed will provide similarly in the future for policy rates as well as the make-up and disposition of the SOMA portfolio.
Finally, the Fed will not likely be ready at the conclusion of this meeting to provide a concrete framework for the initiation and early phase of accommodation removal. Because of waning value in the guidance for tapering, projected to expire in October and the lack of any meaningful replacement in policy guidance, there is room for volatility, currently near historic lows, to become more elevated.
(1) ‘Communication in Monetary Policy’; Vice Chair Janet L. Yellen; At the Society of American Business Editors and Writers 50th Anniversary Conference, Washington, D.C.; April 4, 2013