The Fed’s effort to manage market expectations and aggregate demand through forward guidance may generate as many inconsistencies and misinterpretations as benefits, particularly as the Fed constantly changes its guidance. The Fed’s economic forecasts and assessment of the future appropriate path of the Federal funds rate add to the mixed messages and confusion.
The Fed’s forward guidance on when it may taper its asset purchases and the timing of rate hikes attempts to suppress interest rates until economic growth strengthens. But the longer the economy recovers from financial crisis and recession and the more the unemployment rate falls, potential inconsistencies arise between the Fed’s monetary policy and its long-run objectives. The appropriateness and sustainability of the Fed’s projection of a sustained negative real Fed funds rate through year-end 2016 and an ever-expanding Fed balance sheet are increasingly questionable as economic growth pushes the unemployment rate to its natural rate.
The Fed’s efforts to be transparent have not clarified key issues, only raised questions about the merits and risks of its policies. If the Fed’s longer-run inflation target is 2 percent and it views its appropriate long-run Fed funds target as 4 percent, does a 1.75 percent-2 percent Fed funds rate at year-end 2016 make sense when it projects the unemployment rate to be 5.4 percent-5.9 percent and core inflation 1.7 percent-2.0 percent? Is the Fed’s long-run inflation objective really 2 percent, even though it has indicated that temporarily higher inflation would be accepted, even welcomed? How reliable are the Fed’s projections as forward guidance, when the Fed changes the parameters of its guidance, such as downplay the unemployment rate in favor of a broader assessment of “overall labor market conditions”? Left unanswered, these questions add confusion, jeopardize the Fed’s credibility and establish a bad precedent for future monetary policy.
The Fed now augments its quarterly economic and inflation forecasts with its assessment of the appropriate timing (year of first rate hike) and pace (year-end Fed funds rate) of policy firming. In addition to forward guidance linked to the unemployment rate (and labor market conditions), these projections have too many moving parts for a manageable and coherent policy. The Fed’s monetary policy is just too complex: its toolbox is over-used, conflicting and full of confusion.
The Fed’s September forecasts project stronger real GDP growth that exceeds potential growth through 2016, a decline in the unemployment rate to 5.4 percent-5.9 percent in the fourth quarter of 2016 and a gradual rise in inflation to 2.0 percent. Similar to all recent economic recoveries, the unemployment rate has been falling faster than the Fed’s earlier forecasts. This is partly caused by a declining labor force participation rate. The Fed has modestly lowered its 2014 real GDP growth forecast; like most forecasters the Fed is influenced by the most recent data, which have been mixed.
The Fed’s assessment of the appropriate funds rate path is strikingly low relative to these forecasts. In September the vast majority of FOMC members continued to believe the first rate hike would be in 2015 or 2016, and that the funds rate would be 0.75 percent-1 percent at year-end 2015 and 1.75 percent-2 percent at year-end 2016.
Overview of the FOMC Participants’ Assessments of Appropriate Monetary Policy
Source: Federal Reserve Board of Governors Press Release, September 17, 2013 http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf.
The FOMC members’ assessment of the appropriate longer-run target rate is bunched closely around 4.0 percent. This assessment of a 2 percent real Fed funds rate is in line with prior economic expansions and suggests full normalization of monetary policy consistent with a longer-run 5.2 percent-5.8 percent unemployment rate. However, maintaining a funds rate at inflation through year-end 2016, 7.5 years into an expansion when unemployment is at its long-run natural rate is inconsistent with history, suggests excessive and risky monetary accommodation and is without economic rationale.
The Fed has kept the funds rate below inflation since 2008, the longest period in recent history. The last period of sustained negative real funds rate in 1974-1977 resulted in double digit inflation. Historically, following aggressive monetary stimulus during recession and early recovery, the Fed has hiked rates above inflation as the economy strengthens. The Fed now projects such a strengthening and higher inflation that eventually will require more rate hikes. Based on the current sustained ultra-accommodative monetary stimulus and improving economic and labor market conditions, the Fed will be very lucky if inflation does not rise above 2 percent.
Real GDP and Real Federal Funds Rates from 1960-Present
Source: Haver Analytics
The Fed’s forward guidance in preparing markets for eventual tapering has been a mess. The Fed has reversed its prior analysis that related the magnitude of its large-scale asset purchases (LSAPs) to changes in its (negative) “effective” funds rate target (The Fed’s mounting LSAPs now suggest an increasingly negative effective real funds), and now argues that the timing of the tapering of QEIII has no bearing on when it may hike rates. The market has not bought that line of argument, as reflected by the sharp selloff of the Fed funds futures market in response to Bernanke’s May 22 announcement that the Fed was considering tapering and the opposite response to the Fed’s September surprise.
Earlier this year, the Fed linked the timing of its initial rate hike to an unemployment rate of 6.5 percent and (more loosely) the ending of its asset purchases to a 7 percent unemployment rate. But these guidelines were subsequently qualified by Fed members and changed by Bernanke at his recent press conference, when he stated that the 6.5 percent is not a threshold or a target, and that the first rate hike may not occur until the unemployment rate is “significantly below 6.5 percent.” Adding confusion, Bernanke stated that the Fed is focusing on “overall labor market improvements” as much as the unemployment rate. He also backed off from the 7 percent guideline for ending LSAPs, which based on the Fed’s projections would occur in Spring 2014.
Ironically, the constant stream of statements by Fed members about the prospects for tapering led the markets to expect it would take action in September. The Fed funds futures market had priced in a 1.15 percent fund funds rate in December 2015 and 2.25 percent in December 2016, up dramatically from May, before Bernanke initiated the prospects of tapering.
Bernanke’s press conference clarification highlighted the totally discretionary nature of monetary policy: extremely accommodative monetary policy would be maintained long as inflation remains below 2 percent; the Fed is responding to the high frequency data, and not considering the normal lagged impacts of its policies; the focus on overall labor market conditions suggests that the Fed is responding to the labor force participation rate as well as other factors and government policies that affect labor demand and supply. Bernanke noted the Fed’s policies are also being influenced by disruptive fiscal policies.
How forward looking is forward guidance that bases monetary policy on high frequency data releases?
Lost in the public debate about tapering and rate rates has been any rigorous discussion about whether the Fed’s policies have actually stimulated the economy. Nominal and real GDP growth have not accelerated, despite the Fed’s massive quantitative easing and very low real costs of capital. Excess reserves at banks have grown nearly in line with the dramatic growth in the Fed’s balance sheet, as bank lending growth remains weak. Interest rates are now higher than before QEIII.
The Fed argues that without the QEIII (and forward guidance) the economy would have grown much more slowly, and unemployment would be much higher. But this assessment is based on the Fed’s macro model whose longer-run track record has been underwhelming and unreliable. Clearly, a host of non-monetary factors—including lengthy adjustments in the housing sector, household deleveraging, and government fiscal and regulatory policies and the uncertainties they create--have temporarily constrained demand, production and employment. These economic drags are real and are beyond the scope of the Fed’s monetary policies.
The Fed’s asset purchases have influenced have boosted the stock and bond markets and otherwise distorted financial markets--but they have had little impact on the real economy. And while the Fed’s forward guidance has had a measurable short-run announcement effects, its lasting impact is highly uncertain.
The current problem facing the Fed is monetary policy is still geared toward economic and crisis management long after the economy has achieved sound footing and financial markets are functioning efficiently. Forward guidance is increasingly less convincing and effective when it is used to support a monetary policy that is seen as strategically unsound.
The Fed should establish the proper scope of monetary policy, be more circumspect about the efficacy of its policies and their limited ability to affect real problems facing the economy, and establish an exit policy and stick to it.
Mickey Levy is a member of the Shadow Open Market Committee