In recent weeks we’ve been treated to an almost non-stop set of finance news headlines, indicating stocks either rose or fell on rumors of when the Fed will scale back its bond purchases. How can this possibly be important? After all, the Fed is simply swapping one highly liquid federal government liability for another. I can only guess, but my hunch is that the markets are thinking one move the head of us economists, and everyone else as well.
Let’s start with a couple possible long run equilibria, and then work backwards to today. I’d guess that markets expect NGDP to rise somewhere between 34% and 55% over the next 10 years (those figures correspond to annual growth rates of 3% to 4.5%.) For all sorts of reasons, equity prices today would be much higher if markets expected 55% NGDP growth by 2023, as compared to 34% total growth. So it’s no surprise that markets would react strongly to rumors that provided useful information about the likely future path of NGDP. But why are current Fed purchases of securities so important? After all, we are at the zero bound.
Most economists agree that the Fed steers NGDP when we are not at the zero bound, presumably through a policy regime roughly approximated by the Taylor Rule. Let’s also assume that rates are likely to stay near the zero bound for another 3 to 6 years, and then rise gradually. That assumption seems consistent with the yield curve. In that case, post-zero bound Fed policy will obviously have a big effect on the total 10 year growth rate of NGDP.
But it’s also important to recognize that the Fed doesn’t like sudden shifts. Thus even if they’d prefer 55% total growth, if they are far short of that path 6 years from now then they are unlikely to do a sudden push to catch up over the final 4 years. Thus it matters a lot where the economy is when the zero bound period ends.
The Fed’s big decision will be how fast to adjust its various policy instruments in the face of nominal economic growth data. Thus they might keep rates at 0% for two consecutive years of 5% NGDP growth, or they might begin ratcheting them upward after just two quarters of such growth. We simply don’t know–despite the so-called “Evans Rule.”
Here’s why I think the markets care so much about the possible phase out of QE:
1. Before the Fed begins actually raising interest rates, it will offer hints that it plans to raise rates at a series of FOMC meetings.
2. Before the Fed offers hints that it is thinking about raising rates, it will end QE3 (or QE4.)
3. Before the Fed ends QE3, it will offer hints that it plans to end QE3 at a series of FOMC meetings.
4. Before it offers hints that it is considering ending QE3, it will scale back QE3.
5. Before it scales back QE3, it will offer hints that it plans to scale back QE3.
You could argue that we have already reached step 5. The speed at which we move from one step to another, and more importantly the condition of the economy (NGDP growth) as we move from one step to the next, will largely determine whether NGDP ends up 34% higher in 2023, or 55% higher.
You might wonder why the Evans Rule didn’t make all this transparent. The basic problem is that the Evan’s rule is not a series of precise targets, but rather a sort of “guardrail” preventing excessive monetary stimulus, but also preventing premature tightening. It also ignores QE, the policy du jour, and describes those guardrails solely in terms on the decision to raise interest rates. Thus the Evans Rule might well be consistent with either 34% or 55% NGDP growth over 10 years. Indeed the Japanese have come close to adhering to the Evans Rule for 2 decades (assuming a lower natural unemployment rate in Japan), and have seen less than 0% NGDP growth over 20 years.
You can see this most clearly in the mixed signals coming out of the Fed. Top Fed officials have complained about the effects of fiscal austerity. Top Fed officials have also indicated that they are considering a tightening of monetary policy. These statements seem contradictory–does the Fed want faster NGDP growth, or not?
No wonder the markets are confused–the policymakers they are trying to read are equally confused. But give the markets credit; at least they understand that monetary policy is the key right now. Any hint as to more or less monetary stimulus should have a major impact on asset prices. And it does.