The Wall Street Journal published an article this morning that offers a glimpse into the divisiveness in policy stances within the Fed’s Board of Governors as the economy hits a crucial inflection point on our road to recovery. Although this latest FOMC Statement still only had one dissenter, the rest of the Board was far from united in deciding to embark on QE Lite. With markets set to open decidedly lower today, it is a particularly intriguing time to discuss the future of Federal Reserve policy, but first let’s take a look at some of the debate from this latest FOMC meeting.
Whereas Alan Greenspan ran the FOMC as his own mini-dictatorship in which he required unanimous consent with his own views, Ben Bernanke takes a different, more democratic approach. This offers us some important insight into what policy maneuvers we should expect from the Fed moving forward:
The meeting was a case study in Mr. Bernanke’s management style, which reflects his days as chairman of Princeton University’s economics department when he had to manage a collection of argumentative academics with strong personalities and often divergent views. Mr. Bernanke encourages debate and disagreement, and then weighs in at the end with his own decision, which has helped him win loyalty at the Fed, even among those who disagree with him, several officials say.
Seemingly this particular debate only set the stage for what is to be a much larger, more contentious debate moving forward:
The debate over the decision to keep the Fed’s $2.05 trillion stock of mortgage debt and U.S. Treasury holdings from shrinking, described in interviews with several participants, set the stage for a more consequential discussion inside the Fed that remains very much alive: what to do next, if anything, about America’s stubbornly weak recovery and troublingly low inflation.
And the Fed members all:
…seek to avoid either deflation, a broad decline in prices and wages, or an upsurge of inflation. And they share a strong desire to get the economy growing fast enough to sustain a recovery without unusual government support.
Basically the Fed understands that the stakes are incredibly high right now. As we all know, the real, consequential debate is whether the Fed should restart quantitative easing altogether. While it appears that it would have been difficult to build a consensus within the FOMC to move towards all out quantitative easing, market action alone necessitated some form of tweaked policy:
Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed’s portfolio, had grown concerned….The Fed’s portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. That in turn meant the mortgage-backed securities held by the Fed were being paid off.
Not only did the Fed’s balance sheet shrink since the last FOMC meeting, but so too did markets encounter a whirlwind of volatility. Many market observers had expected, or rather had the hopeful expectation, that the Fed would unleash a full bout of QE 2.0 in light of the recent weakness in equity markets. However, according to the WSJ, the debate focused extensively on whether to maintain the balance of the Fed’s existing portfolio, and did not broach the topic of a new round of quantitative easing beyond a discussion as to whether a move to maintain the balance sheet would lead market participants to expect more easing.
The debate over the maintenance of the present portfolio size was seemingly contentious enough to make it sound like all out quantitative easing would be a tough sell to the FOMC at present. However, much of that seems to result from the fact that many at the Fed do not presently see enough deflation to warrant some sort of action. In reading the WSJ article, and considering the quotes offered from both present and past FOMC members, much of it seems like a “feeler” in order to gauge market sentiment towards another round of quantitative easing. The article concluded with the following observation:
One thing is clear: Mr. Bernanke, though striving for consensus, is determined to avoid mistakes of past central bankers that created devastating bouts of deflation. As a Princeton professor in the 1990s, Mr. Bernanke lectured Japanese officials for being too timid about combating deflation. And in now-famous remarks he delivered as a Fed governor at a 90th birthday celebration for Milton Friedman in 2002, Mr. Bernanke promised the Fed would never allow a repeat of the deflation of the 1930s.
If his background as a professor is any indicator, then we should most certainly expect a more aggressive policy move from the FOMC in the near future. In my recent FOMC preview, I offered some quotes from Bernanke’s pre-Fed Chairman days to highlight some of his beliefs. We must remain cognizant of the fact that when facing deflation, quantitative easing is not the only tool remaining in the Fed’s arsenal: inflation targeting remains a realistic possibility. In a paper entitled Japanese Monetary Policy: A Case of Self-Induced Paralysis?, then Professor Bernanke offered the following critique of the Bank of Japan’s reluctance to use inflation targeting in its fight against deflation:
With respect to the issue of inflation targets and BOJ credibility, I do not see how credibility can be harmed by straightforward and honest dialogue of policymakers with the public. In stating an inflation target of, say, 3-4%, the BOJ would be giving the public information about its objectives, and hence the direction in which it will attempt to move the economy. (And, as I will argue, the Bank does have tools to move the economy.) But if BOJ officials feel that, for technical reasons, when and whether they will attain the announced target is uncertain, they could explain those points to the public as well. Better that the public knows that the BOJ is doing all it can to reflate the economy, and that it understands why the Bank is taking the actions it does. The alternative is that the private sector be left to its doubts about the willingness or competence of the BOJ to help the macroeconomic situation.
What really remains a mystery is what exactly will the Fed look for to take a more proactive policy stance. The allusion to Bernanke’s academic days makes it sounds all but conclusive that the Fed will in fact do something more moving forward, but when exactly remains a mystery. Is the FOMC waiting for tangible signs of deflation? Some sort of catalytic event in capital markets? More time to build a consensus within the FOMC for action? Only time will tell, but we now know that the FOMC remains as divided as everyone else on which, if any policy to pursue.