Fed: Those Two Papers

Published on November 7, 2013

The two papers being presented today at an International Monetary Fund’s annual research conference by William English and David Wilcox, the heads of the Federal Reserve Board’s monetary affairs and research and statistics divisions respectively, have stirred no small amount of speculation that they were intended to prepare the markets for an imminent change in the 6.5% unemployment threshold.

A couple of points are worth making.

*** First, staff research papers, especially thoroughly researched and modeled ones started last spring when the IMF first asked for research topics, are just not rolled out and timed to neatly fit into a specific messaging agenda for an imminent policy change. That the papers were prematurely leaked in advance of their presentation by a major Wall Street house says more about the spin put on them that just happened to suit the firm’s arguments than it does about any hidden agenda by the Fed. ***

*** While the two papers are not intended to signal a lowering of the unemployment threshold, they are, however, “intentional” in that they do reinforce the arguments for a stronger and more credible forward policy guidance on rates — especially after crossing the unemployment threshold. In that sense, the papers reflect the strong activist leanings of both the senior Board staff and a firm majority of the Federal Open Market Committee in favor of an aggressive monetary policy at the zero lower bound, with the increasing emphasis on “changing the mix” of policy tools to the reinforced rates guidance over the $85 billion a month in bond purchases. ***

*** Directionally then, we have no qualms with the subsequent pricing that has pushed back the date of the first rate hikes. We do still think that if the data provide even a minimum of cover, the very strong leanings across the FOMC, dove and hawk alike, is to offset the winding down of the additional accommodation of the QE — and sooner rather than later — with the ample accommodation of a reinforced guidance on lower for longer rates. Adjusting the Numerical Thresholds — as we have written repeatedly (see SGH 10/1/13, “Fed: Forward Guidance, Fiscal Retrenchment, and the Taper”) — is among the many options under active discussion since at least last summer. ***

Arguments for Aggressive Monetary Policy

Both of the papers presented today are extremely interesting and pertinent to the decisions the FOMC will soon need to make. That both include the optimal policy path in their scenarios that Vice Chair Janet Yellen laid out in a series of previous speeches adds to their flavor and attention, but more than anything, they reflect the culmination of staff thinking as it has evolved since policy reached the zero lower bound.

We suspect the Wilcox-led paper, “Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy,” strongly reflects the thinking and concerns of both Yellen and Chairman Ben Bernanke, namely, that the massive contraction in aggregate demand in 2008-2009 had a spillover impact on the supply side, probably bringing trend productivity down that would normally limit the Fed’s room for fear of inflation risk. These, however, are hardly normal times, and the paper lays out arguments albeit with caveats that the supply side hit can be corrected by a very aggressive monetary policy.

The case made on lowering the thresholds that drew so much attention in the English-led paper “The Federal Reserve’s Framework for Monetary Policy– Recent Changes and Questions” is in fact hardly the first argument to be made about using lowered thresholds to potentially reinforce the rates guidance. A downward adjustment in the unemployment threshold has been actively discussed since at least the June meeting.

On that note, even amid the debate over the eventual adoption of the 6.5% unemployment threshold last December, there were arguments it would prove to be a too hawkish line in the sand in due course. And so here we are indeed.

The paper is in fact mostly geared toward laying out scenarios that again assume the need for aggressively accommodative monetary policy. It mentions both NGDP targeting and raising the inflation rate as options (both with lackluster enthusiasm), but more to the current debate, it maps out the likely paths of policy outcomes if the unemployment threshold was lowered AND was credible and wholly embraced by the market.

Again, as staff papers are supposed to do, they are both descriptive rather than prescriptive, using the latest Board modeling to lay out the options for the FOMC.

Threshold Change Resistance, but Progress

And on that score, it has to be said there remains considerable resistance to the idea within the FOMC to do so. The reasons are twofold — and we might add, are shared more widely to varying degree than may be assumed, and which also makes the timing of any potential adjustment in the thresholds difficult to assert with any conviction.

First, there is a concern that a change in the thresholds would undermine their already less than solid credibility, for if they can be changed once, they can be changed again; in effect, a change would only be pointing to the underlying subjective judgment rather than any sort of rules-based guidance.

Second, the Fed has already stressed the “threshold not a trigger” messaging and so why bother, especially since at least some on the FOMC would like to keep some flexibility in case the base case of NAIRU being around 5.5% is flat out wrong and it is indeed much higher.

It is also interesting to note as well that the English paper argues the greater bang for the buck would come in changes to the unemployment threshold rather than messing with the inflation safeguard threshold.

But while lifting the inflation target is simply not in the bounds of the likely any time soon, the tweak being debated within the Fed system to the inflation threshold is to add rather than change the threshold, by bolting on a 1.5% lower band to the 2.5% upper safeguard over the medium term. It is in fact probably where the best odds on a consensus lies, especially if those “transitory” downward price pressures annoyingly persist against forecast.

Nevertheless, assuming the data doesn’t turn south but either shows an economy gathering renewed momentum or at least trudging along at its current sub-par pace, we still believe the doubts will be overcome with a consensus to tweak the unemployment threshold downward and perhaps add a deflation safeguard to the inflation threshold coming together as early as December — the one year anniversary since the adoption of the Numerical Thresholds would give a nice continuity to it — and no later than March.

Reframed Expectations

For now the papers, and the speeches since the October meeting and the forthcoming ones in the run up to the December meeting should all be framed in the context of an ongoing “re-education” of the market and to re-frame expectations after the misfire of the premature taper talk of last summer.

Fed officials were never sure of the potency in the transmission of QE into financial conditions, much less the real economy, or the extent to which the QE and the rates guidance were entwined in the market expectations. Even if their models and their internal assumptions were to the opposite, that the market saw such a sharp spike in yields — 3% is more or less where the Fed assumed the ten year would be after QE is over — and the rate pricing brought forward told them two things, it turns out QE is pretty damn effective after all, but two, of course, the two policy tools are deeply linked.

Since summer and the September decision, they now know a hell of a lot more about transmissions and linkages, and they are determined to make sure they get the sequencing of the messaging right this time. The open-ended regime has turned out to be a bit of a troubling burden in trying to communicate its ending.

So for now firmly embedding the guidance on rates into market expectations is seen as absolutely crucial. The papers today should be seen in the context of a broader and ongoing process putting more of the focus on the rates guidance to ensure the looming wind down of QE goes as smoothly as possible, and that the rate guidance is both as credible and effective as possible.

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