The Fed's Conditional Tense
(Originally published here.)
Wall Street took the weekend to mull over the Federal Reserve's plans to end its easy-money ways over the next few years. It still doesn't like what it sees.
This morning, eurodollar futures have priced in another rise in Fed's expected policy rate, continuing a trend that began last month. The markets seem convinced that the Fed has set its plan for ending monetary stimulus and will execute it regardless, even though that's precisely what its chairman Ben Bernanke promised it wouldn't do in his press conference last week.
The "policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook, as well as on the cumulative progress toward our objectives," Bernanke said.
Nobody believes him because he broke his promise even as he made it. He announced tighter monetary policy despite disappointing economic data over the past month. James Bullard, president of the Federal Reserve Bank of St. Louis, made the point in a statement explaining his dissent from the Fed's announcement.
The exit strategy's announcement, Bullard wrote, was "inappropriately timed." It signaled "a step away from state-contingent monetary policy" -- that is, a promise to let the pace of economic healing dictate the pace of monetary withdrawal. Instead, it looked as though the Fed had "calendar objectives" in mind. Bullard elaborated his position in a later interview.
The monetary exit that markets now anticipate matches the predictions of a "Taylor rule" which sets interest rates based on inflation and unemployment -- but only if you believe the inflation and unemployment numbers from the Fed's forecast. (See this simulation.) Those forecasts have tended to be too optimistic. Wall Street is expecting the Fed to withdraw its stimulus even if the data disappoint.
How can the Fed put this right? It needs to stop thinking in terms of "finish lines." It's promised to keep its policy rate close to zero at least until unemployment drops below 6.5 percent -- and maybe for some time after that. But it hasn't set a condition for the economy's pace of expansion as it crosses the line. The Fed needs to start talking about "escape velocity" as well. For instance, it could promise to keep policy accommodative until the economy grows at an annual rate of more than 2.5 percent and monthly growth in payrolls exceeds 200,000. That would convince the markets that bad economic results will extend the monetary stimulus -- and make the promise Bernanke has already made more credible.