The talk of the town at this past weekend’s Jackson Hole monetary policy conference was a paper presented by Arvind Krishnamurthy and Annette Vissing-Jorgensen on Friday. At the annual FRB-KC symposium, the two academics argued that the Fed should taper its purchases of US Treasuries while increasing its purchases of mortgage-backed securities. That certainly is a novel variation on the QE tapering theme that has been unsettling financial markets since May 22, when Fed Chairman Ben Bernanke first raised the subject.

Adding to the influence of the two economists is that Bernanke mentioned another one of their papers in a footnote of his presentation at last year's conference. In his speech back then, the Fed Chairman focused mostly on QE, also known as "Large-Scale Asset Purchases (LSAP)" in Fed jargon. He admitted that it’s unconventional and has been mostly a “process of learning by doing.” It’s worth rereading his comments in light of recent developments. Most noteworthy is the following quote:

How effective are balance sheet policies? After nearly four years of experience with LSAPs, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. … Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP ["Operation Twist"], found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.

Here’s the rub: The 10-year Treasury bond yield has spiked by 116 basis points from this year’s low of 1.66% on May 2 to 2.82% on Friday. That happened mostly as a result of all the Fed’s chatter about tapering QE. Oh well: Easy come, easy go. I presume that Bernanke must view the backup in yields as economically meaningful! QE was an experiment from the beginning, as Bernanke admitted. If the Fed does phase out QE, it will most likely have to provide more monetary stimulus through forward guidance, as discussed below.

The sharp increase in yields caused by the QE tapering talk suggests that the Fed's bond purchases inflated a big bubble in the bond market. As I’ve noted previously, the 10-year yield normally tends to trade around the y/y growth rate in nominal GDP. The jump in yields is normalizing this relationship. The Fed’s tapering talk has caused investors around the world to taper their holdings of bonds. That’s starting to poke holes in other bubbles as well, particularly emerging market bonds, currencies, and stocks.

(Based on an excerpt from YRI Morning Briefing)

In her speech at Jackson Hole today, IMF Chief Christine Lagarde sounded the alarm on the recent turmoil in emerging markets. Their currency and bond markets have been roiled by QE tapering talk in the US as capital flows back to the developed world. Her basic message was that the Fed and other central banks should consider the impact on other countries when exiting their unconventional monetary policies. In the speech titled, “The Global Calculus of Unconventional Monetary Policies,” she said:

So this is my main message today: We need to work better together to understand more fully the impact of these unconventional policies--local and global--and how that affects the path of exit. And, above all, we must use the time wisely and not waste the space provided by unconventional policies. Global policymakers--all policymakers, within countries and across countries--have a responsibility to take the full range of actions needed to restore stability and growth, and to reduce imbalances.

(Based on an excerpt from YRI Morning Briefing)

Today’s minutes of the July 30-31 FOMC meeting suggest that QE tapering is likely to begin following the next meeting on September 17-18. Here are some of the clues:

1) On the economy. Economic growth was slower during the first half of the year than many participants expected. They mostly blamed tighter fiscal policy for the slowdown. Slower growth overseas also slowed exports. Looking ahead, they “generally continued to anticipate that the growth of real GDP would pick up somewhat in the second half of 2013 and strengthen further thereafter.” They cited several reasons why this might happen, including “highly accommodative monetary policy, improving credit availability, receding effects of fiscal restraint, continued strength in housing and auto sales, and improvements in household and business balance sheets.” On the other hand (since many of them are economists), the participants are worried about “recent increases in mortgage rates, higher oil prices, slow growth in key U.S. export markets, and the possibility that fiscal restraint might not lessen.”

2) On the wealth effect. Participants expect that recent high readings of consumer confidence and rising household wealth will boost consumer spending. However, a few of them cautioned that the wealth effect might be weaker than in the past if consumers might not view rising equity prices as lasting and if extracting home equity is harder to do now. The participants mostly expect that housing activity will continue to improve and that home prices will continue to rise despite the rise in mortgage rates. They are counting on strong pent-up demand to keep housing going. However, they are concerned that mortgage refinancing has dropped sharply.

3) On employment. The committee is impressed with recent payroll employment gains through June. However, the minutes noted that the unemployment rate remains high and that the participation rate and the employment-to-population ratio are low. Furthermore, there are still too many people working part-time for economic reasons. In addition, “It was noted that employment growth had been stronger than would have been expected given the recent pace of output growth, reflecting weak gains in productivity.” Not mentioned was the possibility that the slow pace of GDP growth during the first half was consistent with the trend to hire more part-time workers.

4) On inflation. There was a wide range of opinions on when inflation might rise back to the FOMC’s 2% target. However, more participants expected inflation to remain below 2% for some time than expected a fast pickup:

A few participants, who felt that the recent low inflation rates were unlikely to persist or that the low PCE inflation readings might be marked up in future data revisions, suggested that, as transitory factors receded and the pace of recovery improved, inflation could be expected to return to 2 percent reasonably quickly. A number of others, however, viewed the low inflation readings as largely reflecting persistently deficient aggregate demand, implying that inflation could remain below 2 percent for a protracted period and further supporting the case for highly accommodative monetary policy.

5) On bond yields. The minutes acknowledged that the financial markets were confused by the message in the FOMC’s statement following the June meeting and Fed Chairman Ben Bernanke’s subsequent press conference. Both might have “heightened financial market uncertainty about the path of monetary policy and a shift of market expectations toward less policy accommodation.” However, the participants were mostly satisfied that they had succeeded in clearing up the confusion, as various Fed officials stressed that “a highly accommodative stance of monetary policy would remain appropriate for a considerable period after purchases are completed.” In other words, the federal funds rate will remain near zero long after QE is terminated.

As a result, many participants felt that the markets now understand the game plan (whatever it is): “A number of participants mentioned that, by the end of the intermeeting period, market expectations of the future course of monetary policy, both with regard to asset purchases and with regard to the path of the federal funds rate, appeared well aligned with their own expectations.” Of course, since the end of July, bond yields have continued to rise, suggesting that the markets aren’t as aligned with their views as they thought back then.

At the July meeting, “some participants” were concerned that the rise in bond yields could slam the brakes on the economy. However, “[s]everal others” were much less worried about the backup in yields. Maybe more of them are now that yields have continued to spike higher.

6) On QE. The minutes confirmed that “almost all participants” felt “broadly comfortable” with the plan for tapering QE presented in Bernanke’s June post meeting press conference and in his July monetary policy testimony. If the economy continued to improve, with the unemployment rate heading down to 7% and the inflation rate rising back to 2% by mid-2014, then QE would be terminated by then.

7) On forward guidance. The committee also discussed what to do about its forward guidance, and decided to reaffirm that 6.5% remains the threshold for the unemployment rate. The FOMC won’t even start talking about raising the federal funds rate until the jobless rate falls to that level. However, “several participants” were willing to consider lowering this threshold “if additional accommodation were to become necessary or if the committee wanted to adjust the mix of policy tools used to provide the appropriate level of accommodation.”

(Based on an excerpt from YRI Morning Briefing)

Today’s minutes of the July 30-31 FOMC meeting note that the Fed’s staff is working on a new monetary policy tool. It’s actually a variation of the Fed’s traditional overnight reverse repurchase agreement facility. However, instead of the rate being determined by the market, it will be fixed by the Fed. This will allow the Fed to drain reserves from the banking system at a fixed rate:

In support of the Committee’s longer-run planning for improvements in the implementation of monetary policy, the Desk report also included a briefing on the potential for establishing a fixed-rate, full-allotment overnight reverse repurchase agreement facility as an additional tool for managing money market interest rates. The presentation suggested that such a facility would allow the Committee to offer an overnight, risk-free instrument directly to a relatively wide range of market participants, perhaps complementing the payment of interest on excess reserves held by banks and thereby improving the Committee’s ability to keep short-term market rates at levels that it deems appropriate to achieve its macroeconomic objectives.

This is another indication that the Fed is setting the stage for the eventual tightening of monetary policy.

In a letter today to Chancellor of the Exchequer George Osborne, BOE Governor Mark Carney ties the central bank’s forward guidance to the unemployment rate, which is currently at 7.8% in the UK. The BOE’s Monetary Policy Committee (MPC) will keep interest rates near zero until the jobless rate falls to 7%:

In its assessment the MPC has concluded that explicit forward guidance can enhance the effectiveness of the exceptionally stimulative monetary stance in three ways. First, it provides greater clarity regarding the MPC's view of the appropriate trade-off between the horizon over which inflation is returned to target and the speed with which growth and employment recover. Second, it reduces uncertainty about the future path of monetary policy, in particular helping to avoid the risk that market interest rates rise prematurely as the recovery gains traction. Third, it gives monetary policy greater scope to explore the potential sustainable level of employment and output without putting price and financial stability at risk. In these ways, forward guidance can help to secure the recovery that is now in train.

In light of that assessment, the MPC agreed at its meeting on 1st August--and is announcing today--forward guidance about the future path for monetary policy. In essence, the MPC intends at a minimum to maintain the current exceptionally accommodative stance of monetary policy until economic slack has been substantially reduced, provided that this does not put at risk either price stability or financial stability. In practice, that means the MPC intends not to raise Bank Rate above its current level of 0.5%, at least until the Labour Force Survey headline measure of unemployment has fallen to a threshold of 7%. While the unemployment rate remains above 7%, the MPC stands ready to undertake further asset purchases if additional stimulus is warranted. But until the unemployment threshold is reached, and subject to maintaining price and financial stability, the MPC intends not to reduce the stock of asset purchases financed by the issuance of central bank reserves. Consistent with that, the MPC intends to reinvest the cashflows associated with all maturing gilts held in the Asset Purchase Facility.

The MPC doesn’t expect the unemployment rate to fall below 7% for at least the next three years, i.e., after the third quarter of 2016. If the risks to price stability or financial stability increase over this period, then the unemployment threshold will be “knocked out.” This doesn’t mean that the central bank will start raising rates, but it will “reconsider the appropriate stance of policy.”

FRB-Chicago President Charles Evans (a voting member of the FOMC this year) told reporters today, “We are quite likely to reduce the flow of [QE bond] purchases rate starting later this year--I couldn't tell you exactly which month that will be--and it's likely to wind down over time in a couple or few stages.” Asked if he would rule out voting to start tapering QE at the September 18 meeting of the FOMC, Evans said he "clearly" would not. That makes him the third Fed official in two days to suggest that a September pullback on QE bond purchases is possible. He also said that the federal funds rate would remain near zero until the unemployment rate falls below 6.5%, which he doesn’t expect to happen until mid-2015.

Two other Fed officials this week signaled the possibility of a QE pullback starting in September. FRB-Dallas President Richard Fisher on Monday said he would prefer to start cutting back on bond-buying next month, while FRB-Atlanta President Dennis Lockhart said on Tuesday that the Fed might make reductions starting in September or wait longer if economic growth fails to pick up.

A few weeks ago, FRB-Minneapolis President Narayana Kocherlakota called for the Fed to lower its threshold for considering a hike in rates to 5.5% unemployment. Evans said the Fed is already open to keeping rates low well beyond the current 6.5% threshold, but if Fed officials thought it would be useful to lower the threshold, he would not have a problem with doing so.

In a speech today, FRB-Dallas President Richard Fisher reviews the costs of QE. He acknowledges that the Fed’s bond-buying program has been stimulative:

[D]riving down mortgage rates has certainly assisted a robust recovery in housing, and with it, construction jobs and manufacturing and transportation of materials that go into homes. This was clear from reading the components of the Institute for Supply Management’s manufacturing index released last Thursday, which showed the biggest one-month jump since 1996. Very liberal financing terms for automobiles that we have induced have coincided with an aging of the nation’s auto fleet to regenerate domestic auto sales to the 15.7 million units level.

Then he goes on to outline the major costs of QE:

Counteracting whatever benefits one can trace to the Fed’s unorthodox policies are some obvious costs. First, savers and others who rely on retirement monies invested in short-maturity fixed-income investments, such as bank CDs and Treasury bills, have seen their income evaporate while the rich and the quick, the big money players of Wall Street have become richer still.

Second, the standard return assumptions of 7.5 to 8 percent for retirement pools, as you well know, have been dashed (though I have always felt they were already calculated on an imaginary and politically convenient basis rather than a realistic one).

Third, accompanying the Fed’s growing balance sheet we have seen a dramatic expansion in the monetary base—the sum of reserves and currency. Currently, much of the monetary base has piled up in the form of excess reserves of banks who have not found willing or able borrowers. Other forms of surplus cash are lying fallow on the balance sheets of businesses or being deployed in buying back shares and increasing dividend payouts so as to buttress company stock prices. A basic understanding of demand-pull inflation is “too much money chasing too few goods.” Thus, the excess, currently nondeployed money could prove the kindling of an inflationary conflagration unless the Fed is nimble in managing its effect as it works its way into the economy’s production and consumption of goods and services.

A corollary of reining in this massive monetary stimulus in a timely manner is that financial markets may have become too accustomed to what some have depicted as a Fed “put.” Some have come to expect the Fed to keep the markets levitating indefinitely. This distorts the pricing of financial assets, encourages lazy analysis and can set the groundwork for serious misallocation of capital.

In his prepared remarks today at the press conference following the latest meeting of the ECB’s Governing Council, ECB President Mario Draghi said, “Looking ahead, our monetary policy stance will remain accommodative for as long as necessary.” This statement confirmed July’s forward guidance. He said that the six-quarter recession in the euro area may be coming to an end based on the latest surveys of economic activity. He attributed this improvement in the real economy to the stabilization in financial markets since last summer. Nevertheless, the risks remain on the downside, as lending conditions remain tight.