Fed’s monetary policy : weak growth is the explanation

This post in pdf here : Fed Monetary Policy

Last spring Ben Bernanke spoke clearly about the Fed’s intention to reduce its asset purchases but to keep its interest rate at a very low level [0; 0.25%] for an extended period. During the June meeting the majority of the monetary policy committee (FOMC) agreed to keep them at this level at least until 2015.
To calibrate expectations, Ben Bernanke at the press conference in June was more precise on the way the new strategy could take place. He said that lower purchases could be effective during this fall and that all purchases would stop when the unemployment rate would be at 7%. He also said that the FOMC wouldn’t change Fed’s interest rates level until unemployment rate converges to 6.5% and that inflation rate expectations be higher by at least 0.5% from the Fed’s target of 2%. Bernanke also said that there was no commitment for the future in the way they manage asset purchases. It would be dependent on the economic situation. The Fed wanted to have the possibility to increase or decrease its purchases.

The reason of this change was very clear according to Ben Bernanke. Downside risks on economic activity have receded and it was rational to imagine an exit from the very accommodative monetary policy. The exit from this very accommodative monetary policy was expected to take two or three years.

Looking at all these elements, economists were persuaded that the start of the process would be in September. It was a meeting with a press conference to explain the new strategy and at this meeting new forecasts were published. The other meeting with the same characteristics was in December. But taking December as a benchmark was risky as the unemployment rate could be very close to 7% at this moment. And Bernanke’s commitment was to stop purchases at 7%. This would have a strong impact on the market and it was problematic. That’s why September’s meeting was preferred.

With these elements in mind and with moderately positive economic data the forecast was a reduction of purchases of USD10 to 15bn in September.

This scenario was not the good one
During its September meeting the Federal Reserve has decided to keep its guidance on interest rates and also to postpone the moment where it would reduce its asset purchases. Monetary policy remains very accommodative.

Two reasons can explain this change

1 – Macroeconomic data are milder than what was expected by the Federal Reserve in June even on the labor market where the unemployment rate was down but not for good reasons (lower participation rate while employment rate was almost stable).
This reflects the fact that the American economy lacks of autonomy in its growth process and that it cannot grow rapidly. This situation is problematic as economic policies have been very accommodative for the last five years (except fiscal policy which is less lax since last March). The American economy is not able yet to rebound and to grow by itself to converge rapidly to full employment.   

2 – More recently, the combination of a tighter fiscal policy (since March) and more constraining financial conditions was seen as a drag to economic growth. Bernanke was upset by this situation but he was the catalyst of it. In June he announced that the Fed would revise its monetary policy stance. By doing this he has changed expectations on short term interest rates driving long-term interest rates higher.

This combination could remind us what happened in 1937/1938. After a period of recovery since 1933 the US Treasury and the Fed wanted to normalize their strategies. They became less accommodative. But rapidly growth has faltered and both authorities had to change their way of doing. With that in mind the “no change” option from the Fed can be good news.

These two sources of uncertainty have constrained the Fed not to change its monetary policy. Nevertheless the door isn’t close and Bernanke clearly said that reducing purchases was still on the agenda. He said three things on this point:
1 – A change in strategy can happen even if there is no scheduled press conference. One can be organized rapidly. A reduction in purchase can happened at every meeting now, may be in October?
2 – Bernanke hopes that this operation could start before year end
3 – The threshold of 7% on unemployment rate is no longer a level that would stop purchases contrary to what Bernanke said in June
In fact Bernanke and the Fed had, last spring, defined a too constrained framework. It’s no longer the case.

The Fed also took advantage of this press conference to publish new forecasts. They include now 2016. Bernanke said that before 2016 he still expects headwinds on growth.
Interest rates start going up in 2016 with an average expected level of 2%. In other words on the 17 members of the FOMC 3 have voted for an interest rate increase in 2014. This will not change expected average on fed funds rates at a little more than 0.1%. Three members are not enough to change the picture. In 2015 twelve members expect a rate increase and the expected average for the fed funds rate is 1%. Two members expect that interest rates will be creeping up only in 2016. The average rate will be 2%. The astonishing point is that 2016 is in three years and the FOMC members do not expect that the crisis will be over. They still have in mind a long-term target of 4 % for the fed fund rate. In 2016 it’s only half of the movement that will be done. That’s puzzling and at the end not very optimistic.

GDP growth is expected to be between 2 and 2.3 % in 2013 and between 2.9 and 3% in 2014. This is a bit lower than June’s forecasts. In June the mid-range forecast for 2013 was 2.45%, in September this is just 2.15%. But it is still probably too optimistic for 2013. The carry over growth for 2013 at the end the second quarter is 1.2%. This means that to reach 2.15% (mid-range) GDP growth has to be 5.1% at annual rate both in the third and the fourth quarter. It’s probably too much to be realistic.
The unemployment rate is a little lower with a range of 7.1-7.3 % from 7.2-7.3% in June. For 2014 the same shift can be seen from 6.5 – 6.8 % to 6.4 – 6.8%.

One question everyone had in June was the following: how  was it possible to have a tighter monetary policy with so low expected inflation rate? Inflation expectations were lower than 2% in 2013 and 2014 in June forecast, now they are lower than 2% until 2015. There is no change in core inflation expectations and the 2% target can be reached only in 2015 (the range is 1.7 – 2%). So what is the rationale to change monetary policy with so low inflation expectations? These expectations just reflect the fact that there are no pressures in the US economy and that this later is far from full employment.
May be is it just a signal to say that interest rates will remain low for an extended period of time. One part of the guidance on interest rates is the 6.5% threshold on unemployment rate, the other part is that inflation expectations to higher than the 2% target by 0.5%. The message is clear that the Fed won’t increase its interest rate before long.

In other words, the Federal Reserve has reduced its GDP growth forecasts and its inflation forecasts. Can we then expect a strong downward trend for the unemployment rate?  And if it is the case will it be for good reasons (stronger jobs creation) or for bad reasons as it was the case recently (lower participation rate).
This point implies three remarks:
1 – What will be the role of the unemployment rate in the guidance process? If growth momentum remains on a slow pace then jobs creation will not be strong and will not be able to reduce by itself the unemployment rate
2 -Then, what is the role of the guidance? For the asset purchase process they have changed between June and September, how will they change and are they pertinent for the interest rate process? In other words what kind of credibility does the guidance process implies for the Federal Reserve if they can change the threshold as they want?
3 -The third remark is that as the Fed’s hands are no more tied by precise commitments, there are no reasons to hasten the process of less accommodative monetary policy.

As the path for short-term interest rates is now clearly lower than what was expected by investors, the premium should decrease and long-term interest rates should be well below the 3 % seen before the Fed’s meeting. It will also be positive in the short run for emerging markets. But the current account deficit and the lack of autonomous growth will not be solved by the Fed. So the crisis in emerging countries has just shown the difficulties these countries have to face. They still have to take structural measures to reduce these imbalances.

At the end, the main issue of this Fed’s meeting is that there is a problem on global growth. The USA is not the leader we could expect and their growth will not really spillover the other regions of the world. This means that the world trajectory will remain weak and we cannot expect a rapid improvement in world trade. This can lead to fragility in the European recovery process. And in this environment there is no reason to be tough on monetary policy.
The dramaturgy played by Bernanke and the Fed was just useless and probably costly. Was it due to excessive optimism in Washington? Was it due to an excess in communication? Or was it due to the fact that Bernanke wanted to close the crisis episode before leaving the Federal Reserve? Probably the three factors have a part in the explanation. The question now is about Fed’s credibility and the role of guidance that can be changed when the fed wants to change it. There is a risk of time inconsistency – That’s not necessarily a positive issue.

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