Don’t Dismiss the Communications Value of QE

The minutes of the last FOMC meeting indicated that one group of policymakers was getting anxious about the size and pace of QE:

Several participants emphasized that the Committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved….A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.

Another group saw a different side of the coin:

Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred.

Unsurprisingly, San Francisco Fed President John Williams falls in the latter group.  In a speech today, WIlliams reiterates the labor market objective in setting asset purchase policy:

Critically, we indicated we will continue these purchases until the outlook for the job market improves substantially, in the context of stable prices. I anticipate that purchases of mortgage-backed securities and longer-term Treasury securities will be needed well into the second half of this year.

Clear commitment with no discussion of imaginary risks, except to dismiss inflation concerns:

Some analysts have argued that our policy initiatives have increased the risk of an undesirable rise in inflation. I want to assure you that in no way have we relaxed our commitment to our price stability mandate. We constantly monitor inflation trends and inflation expectations. And we will not hesitate to act if necessary. In this regard, I want to emphasize that we remain committed to our 2 percent inflation target. The 2½ percent inflation threshold in our forward guidance is not a weakening of that commitment.

For now, our default should be that Federal Reserve Chairman Ben Bernanke shares the view that the real benefits of QE outweigh the imaginary costs.  As long is that is true, then Williams will be correct – expect asset purchases to continue at the current pace deep into this year.  What we are looking for, then, are signs that Bernanke’s commitment is wavering as much as that of some of his colleagues.

I do have one quibble with John Williams.  In his description of Fed policy, he states:

We’ve relied on two primary tools. The first is forward policy guidance, that is, public communications aimed at guiding expectations about the future path of the federal funds rate. The second is large-scale asset purchases, which also go by the name quantitative easing. As I’ll explain, both of these tools stimulate the economy by lowering longer-term interest rates.

I would argue that quantitative easing also acts as a communications device that guides expectations; asset purchases are a signal about the Fed’s commitment to accomodative policy.  Indeed, it is the only positive action they can take to signal policy intent; otherwise, due to the zero bound, policy amounts to doing exactly nothing at this point.  Hence why altering the pace of purchases changes expectations about the timing of rate hikes.  I see Ryan Avent has the same idea:

But the discussion alone was enough to influence market expectations. And a change in expectations is a change in policy.

This is something the Fed is only slowly grasping, or at least only slowly building into its policymaking. The Fed initiated asset purchases with the primary goal of having a positive and mechanical effect on the economy: purchases were begun to ease funding conditions in distressed markets, hold down interest rates, and boost asset prices. As a matter of course, it acknowledged that purchases could also operate through an expectations channel, but it did not behave as though this were a significant or justifying benefit of purchase plans.

The reaction of financial market participants to what policymakers might have viewed as a relatively innocuous debate should be a red flag that they need to tread very carefully in changing the pace of asset purchases prior to achieving a substantially stronger labor market.

Bottom Line:  Williams is committed to the current pace of asset purchases. He does not, however appear to place much weight on the communications value of the asset purchases.  Instead, asset purchases work only  “by increasing demand for longer-term Treasury and mortgage-related securities.”  I think they have communications value as well, something illustrated after the release of the January minutes.  Rather than the current nebulous language surrounding asset purchases, the Fed would be better served by communicating a version of the Evan’s rule to tie changes in the asset purchase program to specific economic objectives, presumably some point on the way to the Evan’s rule thresholds.

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