Why El-Erian Should be Reading Steve Williamson

You have likely heard of Mohamed El-Erian, one of the heads at PIMCO. Let’s just say that El-Erian and other major bond investors pay a lot of attention to the conduct of Fed policy and how it’s likely to evolve over time.

Here is what El-Erian has to say about the Fed’s most recent (Dec 12, 2012) policy statement: How Risky is the Fed’s Major Move?

Wow! That is what I suspect many investors said when they heard Wednesday’s policy announcement from the Federal Reserve.
…
The Fed took two major steps on Wednesday, one expected and one less so.

First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013 — a very large number by any measure. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance, and it did so earlier than most expected given theoretical and practical complexities.

Maybe a lot of investors, including El-Erian (and myself, for that matter), were surprised by the Fed’s move. But I can point to at least one economist who hit the nail right on the head; see, Steve Williamson.

First, in terms of the “less surprising” announcement of what was to follow the termination of the MEP, Steve writes:

What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month.

And what we got:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month.

Second, in terms of “more surprising” move of replacing the forward guidance language with a state-contingent rule, Steve writes:

This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. …

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0.

The x in part (i) turned out to be 2.5%, which fell within his predicted range of 2.5-3.0; and the y in part (ii) turned out to be 6.5%, which fell within his predicted range of 5.5-7.0.

Steve didn’t quite nail it exactly, however (as he explains in his follow up piece here). In particular, note that the y = 6.5% is not really a “trigger,”–it is just a necessary (but not sufficient) condition for raising the federal funds rate target. What it really means is that the Fed does not plan to “tighten” as long as unemployment remains above 6.5% (and as long as forecast inflation remains below 2.5%). But the Fed may wish to keep the federal funds rate low even if unemployment falls below that threshold.

(By the way, note that this “trigger” language only applies to the federal funds rate target, not to the Fed’s asset purchase programs.)

In any case, I just thought I’d point this out for those people interested in following the Fed: Steve Williamson is your man. Spread the word.

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