Today’s FOMC announcement, due out at 2:15 p.m. EST is the first Federal Reserve Bank announcement in quite some time to generate uncertainty amongst investors. In the past, many had focused on whether or not the Fed would remove the “extended period” language from the statement. Although some had expected the removal of this language for several rounds of FOMC meetings, this time around, that is increasingly unlikely.
The Fed Fund Futures, an index which tracks expectations on interest rates now makes it clear that any change to interest rates will at minimum be on hold until the latter half of 2011. This change in expectations is a double-edged sword. On one hand, it reflects the fact that growth expectations for the economy have decreased substantially over the course of the past three months. I certainly expect the Fed to express this reality by saying that the downside risk to the economy is a lack of growth and/or deflation, and not inflation.
One the other hand, Fed Chairman, Ben Bernanke has made it explicitly clear throughout both his academic and professional career that the Federal Reserve Bank should use language to shape expectations. Considering both the way in which the economy collapsed, and the extent to which it fell, this is not your typical recession, and as such, Bernanke wants US investors to understand that these low rates will last for more than just a while. They will in fact last for an “extended period.” In a 2004 speech in Japan, while a member of the Fed Board of Governors, Bernanke had the following to say about language as a policy tool:
Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that “policy accommodation can be maintained for a considerable period,” a formulation replaced a few meetings later with the comment that the Committee could be “patient” in removing policy accommodation. These statements conveyed information to markets about the Committee’s economic outlook as well as its policy approach. In my view, this language served an important purpose, illustrating in the process the value of central bank communication. At the time that “considerable period” was introduced, the market was pricing in a significant degree of near-term policy tightening, presumably on the expectation that the sharp pickup in growth in the third quarter of 2003 would induce the FOMC to raise rates. [emphasis added]
Quantitative Easing 2.0?
Heading into today’s meeting, many have been openly discussing the prospect for the Fed to unleash Quantitative Easing 2.0 (QE 2.0), to the point where some even expect it. The Fed has made clear that their intention was not to implement Quantitative Easing as was the case in Japan, but rather to execute credit easing. The following passage from Bernanke highlights the crucial differences, and these differences are instrumental in shaping our expectations:
The Federal Reserve’s approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach–which could be described as “credit easing”–resembles quantitative easing in one respect: It involves an expansion of the central bank’s balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank’s balance sheet is incidental. Indeed, although the Bank of Japan’s policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve’s credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. This difference does not reflect any doctrinal disagreement with the Japanese approach, but rather the differences in financial and economic conditions between the two episodes [emphasis added].
While Quantitative Easing 2.0 is now a far more realistic option that it was in the past, don’t expect any change on this front from the Fed. When Bernanke embarked on his “Helicopter ride” to increase our money supply, the goal was to ease what had been frozen credit markets. At this point in time, although growth remains tepid, credit markets are in fact functioning properly. Even in the latest economic flare up over the past few months, credit spreads stayed within manageable parameters. Moreover, since the Fed stopped open market purchases of mortgage backed securities (MBSs) at the end of March, rather than rise, mortgage rates have continued to fall. it’s not much talked about, but is a very real possibility.
Inflation Targeting is a Wild Card…
While I think QE 2.0 is an unlikely, but real possibility, I think that inflation targeting would be a far more likely and less radical outcome and it would comfortably fit with Bernanke’s desire to use language as an instrument to shape economic expectations. Additionally, this fits nicely with what Bernanke, as a Princeton professor, offered up as advice to the Bank of Japan in its fight against inflation (hat tip to Paul Krugman for the quote):
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.
In this passage, Bernanke specifically asserted that it would not hurt the Bank of Japan’s inflation fighting credentials; however, when asked the about the prospect of inflation targeting in the US just six months ago, Bernanke had the following to say (hat tip to The Economist for the passage):
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
So here, unlike in his academic days, Bernanke is arguing that inflation targeting could hurt the Fed’s credentials as an inflation-fighting institution. Why is it that considering this quote I still think inflation targeting to be a real possibility? Well much has changed since that time. Around when Bernanke had made that quote, the focus had been on how the Fed would go about the withdrawal of all its aggressive monetary policy. Many had been ringing the bells about the looming prospect of hyperinflation, and there remained significant, albeit misguided, concern about inflation in the short-run.
Now that we’re six months down the timeline, with the Eurozone having just gone through a deflationary storm, the risks are much clearer to the downside in growth. One of the Fed’s biggest inflation hawks, James Bullard went on record as concerned about a deflationary situation in the US. The landscape of the policy world has been shifting in the face of current events and this is a significant development unto itself. Although Bullard specifically cited Quantitative Easing as a preferable policy tool, I think that inflation targeting may be the more likely for its ability to anchor expectations of growth and expansion into a bleak economic outlook.
All that being said, I still do not expect outright inflation targeting from the Fed in today’s decision. What I do expect is some sort of stronger language that the downside risk to the economy at the moment comes from a lack of inflation, and as such, the Fed will do all it can to get the economy back to the targeted 2% inflation rate. So while no rigid inflation target will be set, look for some sort of “soft” policy on this front.