On Wednesday, the U.S. Federal Reserve released the minutes of the monetary policy meeting held on October 29 and 30. The minutes revealed what most market watchers and Fed pundits expected: an unwillingness to reduce the rate of asset purchases (as economic conditions have not yet sufficiently improved), concern over market expectations for the eventual wind down, and tepid expectations for the ongoing recovery.
The Fed reduced the target federal funds rate to the zero bound (between zero and 0.25 percent) in December 2008, and it has remained there ever since. As the recession dragged on in the wake of the financial crisis despite the Fed’s accomodative policy and various government bailout and stimulus programs (the Fed has often cited fiscal headwinds as a contributing factor), policymakers were forced to innovate and to fashion and adopt new policy tools in order to encourage growth. One of these tools was quantitative easing, now in its third discrete round.
Through this program, the Fed is purchasing $85 billion worth of agency mortgage-backed securities and longer-term Treasuries each month. These purchases increase the price of those financial assets, which lowers their yield, putting additional downward pressure on long-term interest rates. The intended consequence is to spur spending in interest rate sensitive sectors, which, as Fed vice chair Janet Yellen articulated in her recent testimony before the Senate Banking Committee, should “stimulate a favorable dynamic in which jobs are created, incomes rise, more spending takes place.”
At the meeting, the Federal Open Market Committee — the board of policymakers responsible for the Fed’s open market operations — voted nearly unanimously leave its program of quantitative easing unchanged and to keep the target federal funds rate in a range between zero and 0.25 percent.
It is important to draw a clear distinction between these two aspects of the Fed’s monetary strategy. The federal funds rate is is the central bank’s primary, traditional, and preferred tool to conduct monetary policy.
The federal funds rate is the rate at which banks (depository institutions) loan reserves to one another. The higher the rate, the more expensive it is to borrow reserves — the lower the rate, the less expensive it is. The amount of reserves that a bank has — and, importantly, the ease with which a bank can obtain additional reserves — has a huge influence on liquidity. A bank with insufficient reserves will be unable to make new loans. By raising or lowering its target for the federal funds rate, the Fed effectively has its hand on the throttle of the credit market.
But when — as it is now — the throttle is pushed all the way open and the target rate is as low as it can go (a negative rate is generally agreed to be infeasible) and economic activity is still underwhelming, the Fed must find new ways to try and stimulate spending. Enter quantitative easing, which has a similar effect of lowering interest rates and easing credit conditions, but is a separate, supplementary program.
Understanding this distinction is critical to understanding the Fed’s third unconventional policy tool: the highly controversial strategy of forward guidance, which is what most conversations about the central bank now revolve around. Monetary stimulus can’t last forever — at some point, the Fed will have to reduce and ultimately end asset purchases — and every market participant wants insight into the timeline for this reduction.
Along with its impact on interest rates, quantitative easing drives down currency valuations (which impacts imports and exports), increases inflation expectations (although inflation is pretty much nowhere to be found at the moment), and increases equity valuations. Quantitative easing impacts pretty much every corner of the vast financial market, which means that any changes to the program will impact pretty much every corner of the vast financial market.
This is not news, though. Equity markets around the world threw two so-called “taper tantrums” over the summer when Fed Chair Ben Bernanke simply alluded to the possibility of tapering occurring within the calendar year. Equities plunged and interest rates soared during these tantrums as the markets braced themselves for withdrawal from the monetary stimulus they have become addicted to. When it became clear that the Fed was not yet prepared to taper, assets regained their value — the Dow recently hit an all time high of 16,000 — and interest rates moderated.
Markets both abhor uncertainty and try to price in future events in the present. This makes the fog of war that naturally surrounds Fed policy anathema to market participants who would like little more than to know when and by how much the Fed will taper is asset purchases, and when and by how much it will raise the target federal funds rate.
But perfect (or even reasonable) prescience is a fiction. The Fed has made it clear that the “right time” to taper purchases is dependent on incoming economic data, and that interpreting that data and drawing the appropriate conclusions is an enormously difficult task that necessarily involves some fuzziness. In short, the Fed doesn’t know exactly when it will taper, so the markets can’t know when the Fed will taper, even if the Fed wanted to spell it out.
What the Fed has tried to spell out, though is why it will decide to taper, and through this it has hoped to clarify its decision making process and provide some modicum of foresight to market participants. The first, and perhaps most critical, piece of the Fed’s forward guidance is this: the target federal funds rate will remain unchanged as long as quantitative easing is in effect. First and foremost the supplemental stimulus program must be wound down before the target federal funds rate can change.
So how is the Fed approaching the problem of when to wind down asset purchases? The best answer the market gets is couched in boiler plate text provided in monetary policy statements and the often word-for-word identical updates provided by Fed policymakers in various speeches and testimonies.
In its last monetary policy statement, the Fed said (as it has before) that it will ”closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In judging when to moderate the pace of asset purchases, the Committee will, at its coming meetings, assess whether incoming information continues to support the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective. Asset purchases are not on a preset course, and the Committee’s decisions about their pace will remain contingent on the Committee’s economic outlook as well as its assessment of the likely efficacy and costs of such purchases.”
For the funds rate, it added that it “anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
If the Fed’s forward guidance seems a bit nebulous to you, you are not alone. Market participants have complained from the outset that the policy does not provide the intended clarity, and the communication issue has become a prime topic of conversation among Fed policymakers themselves, as the minutes from the October meeting reveal. The FOMC raised concerns about the market conflating its various policy tools, which may be agitating some problems with interpretation of the forward guidance.
“A number of participants noted that recent movements in interest rates and other indicators suggested that financial markets viewed the Committee’s tools — asset purchases and forward guidance regarding the federal funds rate — as closely linked. One possible explanation for this view was an inference on the part of investors that a change in asset purchases reflected a change in the Committee’s outlook for the economy, which would be associated with adjustments in both the purchase program and the expected path of policy rates; another was a perspective that a change in asset purchases would be read as providing information about the willingness of the Committee to pursue its economic objectives with both tools.”
The minutes go on to illustrate a discussion on how best policymakers could manage market expectations regarding the taper, but no consensus outside of “communicate as effectively as possible about what’s going on” (paraphrased, not a direct quote) was met.
Here’s how the major U.S. indices traded on Thursday: