Wednesday, September 18, 2013

The Fed: Internal Contradictions
The Fed’s transparency policy has made it transparently clear that Fed officials are confused about what to do next. That confusion is abundantly clear when we compare what Fed Chairman Bernanke said at his press conference today and the previous press conference on June 19. Even his latest one was full of internal contradictions. Let’s review:

(1) Do markets matter? As noted above, at last week’s press conference, Bernanke said in his prepared remarks that the FOMC’s decision not to taper was heavily influenced by the backup in bond yields and mortgage rates. Yet when he was asked whether the Fed might be confusing investors and sending mixed signals, he snapped, “We try our best to communicate to markets--we'll continue to do that--but we can't let market expectations dictate our policy actions. Our policy actions have to be determined by our best assessment of what's needed for the economy.” However, the bond market's tightening of financial conditions was one of the major reasons that the Fed voted not to taper, according to Bernanke!

(2) What happened to the “stock theory” of easy money? During his press conference on June 19, Bernanke indicated that he still believed in “the stock theory of the portfolio,” which posits that if the Fed buys bonds at a slower pace that should still put downward pressure on interest rates. Indeed, he even said that just holding onto the securities that have already been purchased and reinvesting funds from maturing issues is stimulative. He did acknowledge that he was puzzled by why bond yields were rising on tapering talk. The stock theory was not mentioned by Bernanke at last week’s press conference.

(3) Is forward guidance on QE still tied to the unemployment rate? At his press conference on June 19, Bernanke specified, for the first time, that 7% is the jobless rate threshold that would mark a substantial improvement in the labor market. He said that the Fed would start reducing its bond purchases later this year if this rate continued to fall toward 7% by the middle of next year, as anticipated by most of the members of the FOMC, according to Bernanke. He expected that QE would be terminated once the jobless rate fell to 7%. Back then, the FOMC knew that May’s rate was 7.6%. Last week, they knew that it had fallen to 7.3% in August.

At last week’s press conference, Bernanke backed away from the 7% threshold: “Last time, I gave 7% as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the--of the state of the labor market overall.”

(4) Is forward guidance on the federal funds rate still tied to the unemployment rate? Bernanke was asked why the unemployment rate threshold for discussing raising the federal funds rate at the FOMC wasn’t lowered at the latest meeting. He chose not to answer the question, simply stating: “There are a number of options that we have talked about. But today, we--as of today, we didn't choose to make any changes to the guidance.” Meanwhile, he effectively did lower the threshold in his prepared remarks as follows:
As I have noted frequently, the economic conditions we have set out as preceding any future rate increase are thresholds, not triggers. For example, a decline in the unemployment rate to 6-1/2 percent would not lead automatically to an increase in the federal funds rate target, but would instead indicate only that it had become appropriate for the Committee to consider whether the broader economic outlook justified such an increase. The Committee would be unlikely to increase rates if inflation were projected to remain below our 2 percent objective for some time, for example; and, in making its assessment, the Committee would also take into account additional measures of labor market conditions, such as job gains. Thus, the first increases in short-term rates might not occur until the unemployment rate is considerably below 6-1/2 percent.
(5) Why is the Fed so intent on seeing inflation rise? The Fed’s inflation target (using the core personal consumption deflator) has been 2% for quite some time. It’s been below that rate since May 2012. At last week’s press conference, Bernanke said that the FOMC is considering setting an inflation floor. If inflation falls to or below this lower bound, then the federal funds rate won’t be raised even if the unemployment rate continues to decline. He added, “I mean, that we should be very reluctant to raise rates if inflation remains persistently below target and that's one of the reasons that I think we can be very patient in raising the federal funds rates since we have not seen any inflation pressure.”

It’s not obvious to me why Fed officials want to boost inflation. The recent decline in inflation has been led by such goods as airfares, used cars, and furniture and bedding. The biggest plunge has been in medical care commodities inflation. Medical services inflation has also been falling. On the other hand, tenant rent inflation rose during August to 3.0% y/y, the highest since May 2009.

Why would it be good for the economy to have rents rise faster? Do Fed officials really want medical care inflation to rebound? These are questions that the Fed chairman did not address in his press conference.

(6) Is there no exit strategy from the Fed’s QE? Bernanke did not address the implications of the Fed’s decision not to taper since just talking about doing so drove yields higher, and raised concerns about the negative impact on the economy among the members of the FOMC. Why won’t that happen again next time the Fed talks about tapering? Why didn’t the Fed proceed with the tiny taper that was widely anticipated and lower the unemployment threshold from 6.5% to 5.5%?

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