Evan Soltas
Sep 25, 2012

How the Fed Has Changed Forever

So I have two additional pieces in Bloomberg which I somehow neglected to post at their times of publication, both of which relate to the Fed's announcement of open-ended quantitative easing.

The first and more recent (Sept. 17) one looks at the Fed's likely next moves:

Many Fed watchers say the change in direction is unfinished. Though the Fed has tied policy to progress in the labor market, the target itself remains unclear...The next step is for the Fed to more clearly define its target, and it appears it may do just that in future FOMC meetings...

What would a better defined target look like?...

Much more likely is a definition of the Fed's policy target that is clarified in increments. There is a direct precedent for this: the Fed's introduction of forward guidance of when it would tighten policy. While the Fed first promised low interest rates "for some time" in December 2008, it later clarified its forward guidance -- first "for an extended period" in March 2009 and eventually with the time period, "at least mid-2013" in August 2011.

"For some time" is as vague a time frame as "ongoing sustained improvement" is a goal for labor market gains. This obscurity weakens the potency of expectations-based monetary policy.

What seems most likely -- and most similar to the evolution of forward guidance -- is that the Fed will reapply its economic projections as policy targets. This could happen twice every quarter as it forecasts growth of real GDP, the unemployment rate, and headline and core PCE over the next three years.

With this strategy, the FOMC could say that it views these projections as generally consistent with the qualitative economic outcome it desires. (It should further affirm that it considers a wider set of data in monetary policy decisions.)

The Fed, in essence, would "target the forecast" by using monetary policy to pursue these objectives in a balanced way.

The second and less recent (Sept. 13) were my comments in advance of the Fed statement:
Today the Federal Open Market Committee, which decides American monetary policy, will issue its bi-quarterly statement. Odds are the Fed will extend its promise of "exceptionally low levels of the federal funds rate" through 2015. (The committee is also likely to announce further asset purchases.)

Should the future fulfill this forward guidance, the U.S. will have seen seven full years of the nominal short-term interest rate sitting at the zero lower bound.
And it will be the fourth time the committee has changed the forward guidance period...

That the Fed is pushing on four years of zero interest rates and extending forward guidance out farther only suggests that policy is all the tighter. It doesn't want to be here still, but it is -- because it hasn't figured out any better options. The root problem is that policy focused on interest rates -- the wheel of monetary policy -- is leading it farther and farther astray from its stable pre-recession path for nominal income.

Today's statement serves as another grim reminder of the Fed's failure to establish sufficiently robust expectations of nominal income so that it can, without fear of real contraction, normalize interest rates.