Monday, April 29, 2013

FOMC Report April 30-May 1, 2013
Martin B. McGuire






At This Meeting

Economic data received on the approach of the March FOMC meeting was reaching above trend and excited some exaggerated hopes for more immediate tapering of the LSAP program.  More recently, economic reports have been below trend and this should temper expectations for an announcement at this meeting that a reduction in the pace of securities purchased is imminent.   

Until more recently, increasingly optimistic economic forecasts had supported growing speculation the Fed would begin tapering the purchase program as soon as mid-year. Mounting concerns about stability risk associated with protracted purchases provide additional, if unsettling reason for scaling back the program as soon as possible.

Clearly, the Fed would prefer to taper the asset purchase program as a result of substantial improvement in labor market conditions.  Still, the Fed appears also to be considering the possibility that the purchase program may need to be terminated for reasons of increased stability risk. 

Recently weaker data should help Fed officials to decide against sharpening public expectations for a tapering of the purchase program prior to the third quarter or possibly the end of the year.  Absent an unlikely consensus Fed view that economic repair has gained needed traction, any additional guidance toward trimming the purchasing levels around mid-year might indicate growing stability risk concerns.    

I expect little change to the statement following the upcoming April 30-May 1, FOMC meeting.  The weaker economic data reports of the last few weeks will not be seen by the Fed to necessarily define even near term prospects.  At the same time, the Beige Book for the period late February to early April was slightly more constructive than the report published in advance of the March meeting.  This disparity will discourage any wholesale changes to the post meeting statement.   

The Beige Book released April 17th indicated a slightly stronger pace of economic activity over the prior reporting period.  In the latest report, two of the 12 districts indicated slightly accelerated levels of growth while the balance of the districts were evenly split in their description of economic growth as either moderate or modest.  While the earlier report showed the bulk of the districts similarly described as five having modest and five experiencing moderate growth levels, the two outlier districts in that case showed slowed rather than accelerated growth. 

Communication in Monetary Policy

Introduction:

I would like to discuss the topic of effective monetary policy communication and will reference a speech by Fed Vice Chair Janet Yellen, 'Communication in Monetary Policy', April 4, 2013 (1).  Dr. Yellen has been charged with chairing a special committee to study Fed communications and she is considered a foremost leading expert in this area.  Her speech highlights much of the current thinking about communication as a policy tool.

The greatest short fall in current thinking about monetary policy communication is that it is widely believed to be a tool for all seasons and that greater application in all cases might be expected to generate superior results. Instead, Fed communication as it has evolved over the last two decades has been shown to have a greater impact on and provide considerable support for the maximum growth half of the Fed's dual mandate.  The Fed failed the challenge of using communication in the 'restrictive policy regime' of 2004-2006 and that failure was a leading cause of the financial crisis.

There is a place for communication in the application of restrictive monetary policy directive.  However, if the Fed is to effectively use communication during a restrictive monetary policy period the volume, characteristics and intent of that communication will need to be quite different from what is used during an easy or accommodative monetary policy regime.  We have become accustomed to the Fed providing guidance for monetary policy over long periods of time.  This has been shown not to work during a 'tightening bias' or restrictive policy regime.  The Fed will need to find a different way to communicate when it next wants to slow credit growth.    

Moving Up Communication Learning Curve

The Fed has moved rather far afield over the last two decades attempting to add clarity to public understanding of monetary policy intent.  Importantly, much of the period over which Fed ‘transparency’ had increased, paralleled what became known as ‘the great moderation'.  Longer expansion periods and milder recessions had become the norm and central banks in general and the Fed in particular were credited to some extent for this improvement. 

Clearly efforts toward increasing Fed transparency coincided with improvements in the economic cycle and it became difficult to refrain from assigning cause/effect characteristics to the benefits from increasingly levels of transparency.

Intuitively it is easy to imagine that economic agents might be better able to make informed decisions when afforded the benefit of Federal Reserve intelligence.  Assuming the Fed has a good understanding for the form of monetary policy application required, if any, to guide the economy toward a greater plane, sharing those findings in advance with the public should promote the attainment of that goal.  That was however not always the consensus view.  

In an April 4th speech by Fed Vice Chair Janet Yellen ‘Communication in Monetary Policy’, she suggested there has been a revolution in FOMC communication; ‘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.’(1) This revolution however is not yet complete and there is more to understand about the effectiveness of monetary policy.

Not too terribly long ago the Fed was much less forthcoming about the reasons for their policy actions.  Suggested reasons for earlier Fed secrecy included; ‘One view was that less disclosure would reduce the risk and tamp down suspicions that some could take advantage of disclosures more readily than others. Some believed that markets would overreact to details about monetary policy decisions. And there was a widespread belief that communicating about how the FOMC might act in the future could limit the Committee's discretion to change policy in response to future developments.’ (1)

Understanding the Feds reaction function as indicated by their actions through time became almost a science in itself.  Economic agents became increasingly adapt at anticipating Fed response to changing economic and money values.  The consistency of the Feds responses led John Taylor (and others) to describe the Fed’s reaction function in a rather straight forward algebraic equation.  Shortly after the Taylor rule was published in 1993, the Fed began to engage more actively in communicating policy action and intent. The first post-FOMC meeting statement was on February 4, 1994.

One shortcoming noted by Yellen in relying on FOMC past behavior for a guide to future policy, as was the norm in less transparent times, was that ‘it gave an advantage to sophisticated players who studied the FOMC's behavior’. (1)  Not surprisingly then, it appears that sophisticated players were expected to benefit (more than unsophisticated players) both from having to read into past behaviors as a guide and as noted earlier from being more ready to take advantage of Fed disclosures.  Apparently in either case it pays to be sophisticated…but I digress.   

Yellen noted another shortcoming of past behavior as a substitute for transparency; ‘Second, while a policy rule such as the one developed by John Taylor explained the course of the federal funds rate much of the time, there were cases when it didn't and when even the experts failed to correctly anticipate the FOMC's actions.’(1)  This may help us appreciate that by providing a ready-use formula for determining ‘appropriate’ Fed policy, Mr. Taylor’s efforts might have created the impetus for increased Fed transparency.   

Later, Yellen describes the transition in 2003 to using communication as a policy tool; ‘In this situation, it told the public that it intended to keep the federal funds rate low for longer than might have been expected by adding to its statement that "[i]n these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period… For the first time, the Committee was using communication--mere words--as its primary monetary policy tool."’(1)  It is important to recognize that the Fed was in an accommodative mode or easy monetary policy stance.  They were making effort to support growth.  This is the most appropriate time to use 'this type' of communication as a policy tool as it can offer clarity and visibility, promoting decision making and risk taking where otherwise economic agents have refrained from taking action as a result of heightened uncertainty. 

Yellen went on; ‘Until then, it was probably common to think of communication about future policy as something that supplemented the setting of the federal funds rate. In this case, communication was an independent and effective tool for influencing the economy. The FOMC had journeyed from "never explain" to a point where sometimes the explanation is the policy.’(1)  And it worked.  Possibly not for reasons some believed, but the economy did recover from the 2003 slump and the timing of that improvement lends some creditability to speculation that the ‘guidance’ of ‘considerable period’ may have supported growth. 

What might be misunderstood or overemphasized is the notion that the promised low 1% fed funds policy rate was the main driver of renewed animal spirits.  A very strong and underappreciated aspect of the guidance was the ‘visibility’ and clarity that communication provided, irrespective of the associated rate.  It helped to replace certainty for uncertainty at a critical juncture.  Clearly, rates were low and potentially simulative in themselves.  The benefit from ‘considerable period’ had much to do with describing a larger chunk of timeline and thus reducing ‘risk premium’. 

Unfortunately, Yellen’s discussion on monetary policy communication completely skipped over the period 2004-2007; a period I have maintained since 2006 containing the greatest mistake in central bank history.  Some still believe that the low rate of 1% held for roughly one year was a catalyst for the financial crisis.  Others would include the relatively low rates that prevailed between 2004 and 2006 as being a root cause.  For my guide, it was the Fed’s communication used during the ‘restrictive monetary policy regime’ that was a primary contributor to the excesses which led to the credit crisis and subsequent recession. 

From May 2004 through December 2005, in 14 consecutive post-meeting FOMC statements the Fed guided expectations by advising it intended to remove accommodation at a ‘measured pace’.  At each and every meeting following these utterances, the Fed raised the fed funds policy rate by 25 basis points.  Not unlike the use of ‘considerable period’, ‘measured pace’ was an ‘effective tool for influencing the economy.’ However, the extent to which this guidance served the Fed mandate for maximum growth was sorely misunderstood.  

In my humble view, it is essential that we come to a better understanding that transparency does not act equally as a servant to the dual mandates of Fed policy, but extensively favors support for the maximum growth (employment) mandate.  More work is needed to prove this, but empirical evidence to date should be sufficient to excite enough interest to move forward with these studies. 

First, transparency might be likened to a clean windshield.  Such will benefit a driver on all road conditions.  The clean windshield will allow a driver to see as far as the horizon on a straight unobstructed highway.  However that same clean windshield will not provide confidence enough to accelerate in curvy mountainous terrain.  In either case, the benefit of transparency is limited to the extent it helps define, clarify and possibly extend the limits of our ‘visibility’.  It needs to help us see the future with greater certainty.  The visibility on a straight unobstructed road is grand while visibility on a curvy mountain road is minimal. A clean windshield will not remove the curves from a road.

The economic benefit from Fed communication or transparency is not a view into the inner-working of the Fed, or a better understanding of the Fed’s reaction function. What matters is the extent to which the Fed’s transparency can provide additional visibility or clarity as to what is to happen in the future.

Fed communication ceases to be an effective policy tool (during accommodative policy) in the absence of sufficient levels of visibility and clarity provided, either real or imagined.  By providing additional levels of certainty in times of distress, the Fed can help to encourage animal spirits.  This is what the Fed has been trying to get a handle on when it advises of policy guidance thresholds and timeline references for protracted policy initiatives. 

It appears that communication can be used to help support accommodative monetary policy intent through providing visibility of a longer chunk of the Fed policy time line, thus reducing risk premium and promoting greater levels of certainty and renewed animal spirits.  If transparency that provides greater visibility is used to promote risk taking    Now that we have come to better understand that Fed communication can promote risk taking by providing greater visibility during an accommodative policy period, the Fed may come to learn how to use communication as a way to reduce risk taking when the economy shows signs of overheating and credit conditions have begun to promote increasingly less viable economic enterprise. 

Using communication in a restrictive policy initiative to reduce the level of certainty economic agents have in understanding of the path of policy rates or availability of credit might be an 'effective monetary policy tool'.  For example, the Fed could offer something like this in a post meeting statement; Today the Fed had decided to raise the fed funds policy rate by 25 basis points and will raise the IOER by a similar amount.  Based on growth in credit formation and the prospects for inflation expectations to become less anchored, the Fed today considers likely the need to raise policy rates in the future and may choose to do so in varying increments and will not limit the timing of these actions to FOMC meetings.   

What Went Wrong With 'Measured Pace'

In the failed policy initiative of 2004-2006 the Fed announced 14 consecutive times that it intended to remove accommodation at a ‘measured pace’ and in each instance increased policy rates by 25 basis points at the next FOMC meeting.  This was an inappropriate application of communication as a policy tool.  The visibility provided by the ‘measured pace’ communication or transparency gave economic agents a very large part of the timeline for policy rates.  It provided additional support for economic growth at a time when a lesser amount of accommodation was called for.  Even though the Fed was raising policy rates by 25 basis points per meeting, the ‘benefit’ derived by economic agents in recognizing the extended policy path severely reduced risk premium and more than offset any inconvenience from successively but only marginally higher market rates.

Economic agents sought to monetize the value of the ‘guidance’ by aggressively positioning in leveraged investments with relative certainty in their understanding of the Fed’s policy path for interest rates.  The ‘measured pace’ communication prompted increasing less economically viable investment schemes to vie for capital; having a clear recognition of what would be required of these schemes to vault  policy interest rate hurdles through time.  

Only toward the end of the two years in which this ‘measured pace’ policy prescription was administered did the influence of the earliest tightening efforts take hold as the lag from policy initiation to the time it’s impact was felt in economic conditions had been stretched because of the widely understood policy roadmap. 

Later as the Fed moved away from successive 25 basis point rate hikes, after mid-2006, the benefit of Fed transparency started to wane as that transparency no longer afforded a long look down a long and an unobstructed highway.  Instead, the Fed was unable to provide direction to economic agents through their transparency, as the Fed itself became increasingly uncertain as to the direction monetary policy should take.   

Risk premium rose as the benefits, in the form of visibility and clarity afforded, from Fed communication was reduced to zero.  As risk premium rose, the lag time between policy initiation and its impact on the economy also plummeted rapidly.  The shock of the series of 17 successive 25 basis point rate hikes coming to bear on the economy nearly all at once coupled with the loss of benefit from Fed communication was much more than the now fragile economy could withstand.  Economic agents scrambled to become more liquid as uncertainty reigned and animal spirits were replaced by instincts to take flight.   

There is room for the Fed to better understand the impact of communication in a restrictive monetary policy setting.  In Yellen’s April 4th ‘Communication in Monetary Policy’ speech she indicated that prior to the onset of the financial crisis; ‘The public had grown accustomed to monetary policy that focused on changes to the federal funds rate target, with occasional, and at this point fairly limited, guidance that a particular policy stance would probably last for a while.’(1)  The use of ‘measured pace’ language however was certainly not limited (14 consecutive FOMC meetings) and soon after that language was first used it rightly became recognized as a policy stance that would last for a while.


Communication Today about Duration of SOMA

The Fed should be expected to engage in another newer form of communication when it begins to taper the asset purchase program.  Yellen points out; ‘Current research suggests that the effects of asset purchases today depend on expectations of the total value of securities the FOMC intends to buy and on expectations of how long the FOMC intends to hold those securities.’(1) Therefore, when the Fed announces plans to taper the pace of security purchases, they should be expected to take insurance against too adverse a market reaction by adding back a dose of accommodation in the form of guidance as to how long the Fed might be expected to hold the portfolio. This guidance about how long the Fed might hold its portfolio need not be terribly specific in order to afford some offsetting accommodation. 

Perceptions about the form the exit strategy will take have been reshaped since the Fed first initiated asset purchases.  Initially, it was widely assumed that the Fed would move immediately toward selling accumulated securities when economic conditions warranted lesser amounts of accommodation.  Following the June 2011 FOMC meeting where the Fed published its so called ‘exit principles’ more people came to understand the fed funds policy rate would ‘do the heavy lifting’ to bring about a less accommodative stance.  The Fed will of course also use reverse repurchase agreements, fixed (long) term deposit operations as well as adjustments to IOER in concert with fed funds policy rate changes.

For now we might concentrate on if, when and by how much the Fed might eventually taper its purchase program and if it will at the same time give guidance as to how long they might hold the portfolio before selling any.  Also, let's contemplate the reaction market participants might have to the scale down and completion of LSAP given the growing expectation that fed funds policy rates will be used to do the heavy lifting once accommodation needs to be removed.  We must look carefully at the time line to discern when the Fed might be required to start raising policy fed funds and how it might effectively use communication as a policy tool in those efforts. 
 



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