This morning at 6:27 a.m., Jon Hilsenrath posted a WSJ article titled, “Fed Leaves Markets Guessing.” This excerpt gives the gist:

The comments, given at a congressional hearing Wednesday, gave markets a dose of clarity for a few hours, though a subsequent release of minutes from the Fed's April 30-May 1 Fed policy meeting added to investor anxiety about the Fed's plans. The minutes disclosed that some officials were prepared to start pulling back the program as early as the Fed's next meeting in June, though the group as a whole, too, expressed hesitance.

Fed officials have struggled to fine-tune their communication strategy while they are struggling to fine-time their QE policy. So far, the results have been confusing. The noise-to-signal ratio coming out of the Fed has been rising. Here’s more from Hilsenrath’s article:

The next step by the Fed could be especially tricky. One worry at the central bank is that a single small step to shrink the size of the program could be interpreted by investors as the first in a larger move to end it altogether. [Yesterday,] Mr. Bernanke sought to dispel that view, part of a broader effort by Fed officials to manage market expectations.

If the Fed takes one step to reduce the bond buying, it won't mean the Fed is "automatically aiming towards a complete wind-down," Mr. Bernanke said. "Rather we would be looking beyond that to seeing how the economy evolves and we could either raise or lower our pace of purchases going forward. Again that is dependent on the data," he said.

At 2:03 p.m., just three minutes after the FOMC minutes were released, Jon Hilsenrath posted an WSJ article titled, “Parsing Fed Minutes: Debating When to Pull Back.” His conclusion is that the FOMC is “heading toward some difficult debates on when to pull back its bond buying program.”

Fed Chairman Ben Bernanke testified today on the economic outlook before a congressional committee. In his prepared text, he warned against a “premature tightening of monetary policy,” saying it “could lead interest rates to rise temporarily but would also carry a substantial risk of slowing or ending the economic recovery and causing inflation to fall further.”

But then, in his Q&A session, Mr. Bernanke said that QE might be tapered in the next few months if the labor market continues to improve. That very same afternoon, the minutes of the April 30-May 1 FOMC meeting reported: “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting if the economic information received by that time showed evidence of sufficiently strong and sustained growth….”

Stock prices soared when Bernanke read his prepared text, but then dropped sharply after the Q&A and the release of the FOMC minutes. The Dow Jones Industrial Average finished the day down 80.41 points, or 0.52%, to 15307.17--having moved 276.44 points from peak to trough.

FRBNY President Bill Dudley spoke at the Japan Society in NYC today. His speech titled, “Lessons at the Zero Bound: The Japanese and U.S. Experiences,” was long and long-winded, and reminiscent of Hamlet’s famous soliloquy. The Fed may either increase or decrease its QE purchases “[b]ecause the outlook is uncertain, I cannot be sure which way--up or down--the next change will be.” Near the end of his speech, he dwelled on how the markets might overreact to what the Fed does or doesn’t do:

There is a risk is that market participants could overreact to any move in the process of normalization. Indeed, there is some risk that market participants could overreact even before normalization begins, when the pace of purchases is adjusted but the level of accommodation is still increasing month by month. Not only could such responses threaten financial stability, but also they might make it harder to calibrate monetary policy appropriately to the economic situation. We will need to think long and hard about how best to develop policy in a way that enables us to respond flexibly to a changing economic outlook, but in a way that is not disruptive to the economy.

Picture Jackie Mason playing Hamlet: "To be, or not to be--that is the question. Oy!"

Three economists at the Office of Financial Research of the US Treasury released a working paper today titled, “The History of Cyclical Macroprudential Policy in the United States.” Guess what? It hasn’t worked very well in the past. If it had, we wouldn’t be in this mess. This is from the paper’s abstract:

Since the financial crisis of 2007-2009, policymakers have debated the need for a new toolkit of cyclical “macroprudential” policies to constrain the build-up of risks in financial markets, for example, by dampening creditfueled asset bubbles. These discussions tend to ignore America’s long and varied history with many of the instruments under consideration to smooth the credit cycle, presumably because of their sparse usage in the last three decades. We provide the first comprehensive survey and historic narrative of these efforts. The tools whose background and use we describe include underwriting standards, reserve requirements, deposit rate ceilings, credit growth limits, supervisory pressure, and other financial regulatory policy actions.

Their conclusion: “Both the practical issues discussed above in regard to specific historical actions and the preliminary statistical analysis suggest that cyclical macroprudential actions may indeed be worthwhile, but they are also difficult to implement effectively and subject to many cross-currents in the economy that reduce their effectiveness.”

Fed Chairman Ben Bernanke delivered a speech in Chicago today on “Monitoring the Financial System.” He assured us that the Fed’s Financial Stability Monitoring Program is doing just that, i.e., focusing on systemically important financial institutions (SIFIs), shadow banking, asset markets, and the nonfinancial sector.

The structure of this program is detailed in a recent working paper by the Fed's staff titled, “Financial Stability Monitoring.” The Fed is on the lookout for “evidence of low pricing of risk” in four areas, specifically:

First, the risks of SIFIs are assessed using stress tests, market-implied assessments of the SIFIs, network measures for exposures, and regulatory filings of the institutions. Second, the risks in the shadow banking sector are assessed using a variety of data sources on short-term and secured funding markets, securitizations, and new products. Third, the level of asset valuations is gauged across asset classes, including equity, credit, Treasuries and TIPS, housing values, commodities and farmland, exchange rates, and foreign markets. The assessment of asset valuations is tightly linked to the observed risk taking of SIFI and shadow banking institutions. Fourth, the risks of the nonfinancial sector are assessed in connection with the financial sector developments.

Don’t you feel safer knowing that Big Ben is watching? He has yet to ask, “But how do we know when irrational exuberance has unduly escalated asset values…?” That was the famous question asked by Fed Chairman Alan Greenspan in a December 5, 1996 speech. Nonetheless, the Fed is on the lookout for irrational exuberance, and Fed officials will plant stories and give speeches to remind us that they are ever vigilant.

In his speech, Mr. Bernanke did say, “Systemic risks can only be defused if they are first identified.” He didn’t specify if any have been identified lately. He also didn’t say what the Fed would specifically do if it found irrational exuberance. "Shocks of one kind or another are inevitable,” he observed. However, he believes that “macroprudential” regulations can be designed to reduce the “vulnerabilities” of the financial system to a crisis from such “triggers.”

(Based on an excerpt from YRI Morning Briefing)

Most of boilerplate language in today’s statement was unchanged from that of the previous statement on March 20, 2013:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently 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.

What’s new is the following: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” The previous statement’s language on this topic was: “The Committee 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.”

For the third meeting in a row, only Esther George (FRB-KC) dissented. She “was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.”

“Measuring Economic Uncertainty” is a working paper coauthored by three academic economists. They note that:

In recent years, many commentators have made two claims about economic policy uncertainty. First, that it increased after the start of the 2007-2009 recession because of businesses and households uncertainty about future tax, spending, regulatory, health-care and monetary policies. Second, that this increase in policy uncertainty slowed the recovery from the recession by leading businesses and households to postpone investment, hiring and consumption expenditure. We seek to investigate both claims.

They construct a new measure of economic policy uncertainty (EPU) and examine its evolution since 1985. They find evidence of substantial increases in policy uncertainty in the United States and worldwide since 2007, with their EPU index increasing by more than 50%. Here is one of their major conclusions:

Drilling down into our index we find that the post-2008 increases are driven mainly by tax, spending and healthcare policy uncertainty. Perhaps surprisingly we find no evidence of an increase in monetary policy uncertainty after 2008. One interpretation is that since inflation and interest rates have both been low and stable since mid-2008 onwards, monetary policy is not seen by the news media as contributing to economic policy uncertainty.

Jon Hilsenrath said it all today (Sunday) in his WSJ article about the FOMC meeting scheduled for this week:

"Federal Reserve officials are likely to continue their easy-money policies at the central bank's policy meeting on Tuesday and Wednesday, in part because several recent inflation measures have fallen well below the Fed's 2% target."

That’s a relatively new development. Until recently, Fed officials said that their ultra-easy monetary policy was necessary to reduce the unemployment rate to 6.5%. They said that they would pursue this course as long as inflation didn’t rise more than 50bps above their 2% inflation target. Now they seem to be thinking that with inflation heading below rather than above this mark, there’s all the more reason to stay with the easing course.

Over the past few weeks, the members of the "Federal Open Mouth Committee" were mostly chattering about how they might phase out QE if the labor market continued to improve. They did so at the last meeting of the FOMC on March 19-20. Then, on April 5, March payrolls showed a gain of only 88,000. Now the moderation in the latest inflation data only strengthens the hand of the FOMC’s doves.

In his article, Hilsenrath noted that top Fed officials recently have suggested that they are concerned about the recent decline in inflation. They said that if it persists, then they will favor proceeding with the current bond buying program or even increasing it.

The core PCED inflation rate fell in March to 1.1% y/y, the lowest since March 2011 (Fig. 2). I don’t understand why Fed officials are so convinced that lower inflation is a bad thing. They obviously view it as a sign of economic weakness. They also seem to fear that falling inflation will hurt demand for goods and services by eliminating buy-in-advance attitudes.

Are they aware that much of inflation’s recent improvement (IMHO) is attributable to health care costs? That’s right: The PCED medical care inflation rate was down to 1.7% in March, the lowest since April 1998 (Fig. 3). There have been significant drops in inflation rates for drugs and physician fees (Fig. 4). Does the Fed want to see higher inflation rates in the health care industry so that people will rush to buy medical care goods and services before their prices go up?

Rent inflation has rebounded during the current economic recovery, but now shows signs of peaking (Fig. 5). The CPI and PCED data are nearly identical and show that rent of shelter is up 2.2% y/y. It was actually falling during 2010. It accounts for 17% of the core PCED and 42% of the core CPI. Do Fed officials really want still higher rent inflation?

Do they know what they want? It doesn’t matter to the stock bulls. If the members of the FOMC now believe that both the unemployment and inflation components of their dual mandate oblige them to maintain QE and even to increase it, so be it. QE may be losing its effectiveness in boosting the economy and inflation, but that just leaves more liquidity to float stock prices higher (Fig. 6).

(Based on an excerpt from YRI Morning Briefing)

Here is how Fed Vice Chair Janet Yellen described the Fed’s game plan in a panel discussion at a conference hosted by the IMF on April 16:

By lowering private-sector expectations of the future path of short-term rates, this guidance can reduce longer-term interest rates and also raise asset prices, in turn, stimulating aggregate demand. Absent such forward guidance, the public might expect the federal funds rate to follow a path suggested by past FOMC behavior in ‘normal times’--for example, the behavior captured by John Taylor's famous Taylor rule. I am persuaded, however, by the arguments laid out by our panelist Michael Woodford and others suggesting that the policy rate should, under present conditions, be held ‘lower for longer’ than conventional policy rules imply.

She concluded her short remarks by stating that the Fed’s goal is “to promote a return to prudent risk-taking.” She admits that risk-taking can be taken too far, but reassuringly said she isn’t worried: “I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability.” Ms. Yellen’s only concern so far seems to be that fixed-income investors are “reaching for yield.” Gee, I wonder why they might be doing so? She didn’t mention that margin debt recently rose back to its previous record high. Here it all that she did say:

To put it in context, let's remember that the Federal Reserve's policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy. Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.