And Then There is Bernanke

Lots of Fed chatter in the last week.  For openers, some background from Reuters:

It decided on May 1 to keep buying at an $85 billion monthly pace, and many economists say mixed economic data warrants keeping up the purchases through year-end.

But persistent warnings from more hawkish Fed officials had fanned talk that it might start to wind back soon.

The hawkish Fed officials would be Dallas Federal Reserve President Richard Fisher, Philadelphia Federal Reserve President Charles Plosser, and Richmond Federal Reserve President Jeffrey Lacker.  These are often colorful voices, but as a general rule are not voices that will hold much sway with regards to the pace of easing.  What is much more important is to what extent remaining policymakers are coming along to the same view.  In other words, these three can ruffle their feathers all they want, but that ruffling should not be interpreted as consensus movement within the FOMC.

For consensus movement, turn more toward New York Federal Reserve President William Dudley. Great speech yesterday, but I will narrow my focus with a few points I think are relevant for US policy.  While Dudley is clearly concerned about deflation, this is important:

Similarly, current circumstances in the two countries are different, with deflationary expectations still in the process of being dislodged in Japan.  The BoJ needs to push up inflation expectations, whereas in the U.S. the current level of inflation expectations is consistent with the long-term objective of the Fed.

This speaks to his concerns – or lack thereof – about the current US inflation numbers.  My sense is that he will dismiss those low numbers as long as expectations stay anchored at 2 percent.  Later he says:

Let me give a few examples of how my own thinking may evolve.  In terms of our asset purchase program, I believe we should be prepared to adjust the total amount of purchases to that needed to deliver a substantial improvement in the labor market outlook in the context of price stability.  In doing this, we might adjust the pace of purchases up or down as the labor market and inflation outlook changes in a material way. For me, the base case forecast is not the sole consideration—how confident we are about that outcome is also important.

Here he brings inflation back as an issue in determining the pace of purchases.  But then in the next paragraph:

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be.  But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases.  Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

Which sounds as if inflation is not the primary determinant in the decision to taper.  The labor market is the primary determinant, which might be expected if he believes that low inflation numbers are not a relevant concern in the context of stable inflation expectations.  In such a context, Dudley wants to see to what extent the labor market will feel the fiscal drag.  In other words, be cautious about how far the low inflation story will travel in the FOMC.

To be sure, you can point to yesterday’s speech by St. Louis Federal Reserve President James Bullard as a reason that current inflation is relevant.  From Reuters:

“Inflation is pretty low in the U.S.,” Bullard told reporters after delivering a lecture in Frankfurt. “I can’t envision a good case to be made for tapering unless the inflation situation turns around and we are more confident than we are today that inflation is going to move back toward target,” he said.

But is this the consensus view?  Robin Harding of the FT smartly tweets:

Re Bullard comments, low inflation has always been the main driver of QE for him. Entirely different for Bernanke, Yellen et al.

— Robin Harding (@RobinBHarding) May 21, 2013

I think Harding is right.  With inflation expectations stable, from the consensus FOMC viewpoint tapering will be much more dependent on the labor outlook than current inflation.

Other voices include Chicago Federal Reserve President Charles Evans who raises the prospect of a sharp end to quantitative easing.  From Reuters:

“Another approach, which doesn’t get talked about that much, we could continue to go with $85 billion a month until we decide that absolutely we’ve seen enough improvement, and then bring it to a quick conclusion at that time,” Evans told reporters after the speech.

“That would be a program going into the fall, I would think, because you can’t really have that much confidence to bring it to an end” before that, he said. “I think at the moment the key issue is whether or not it is extremely likely that this (improvement) is going to be maintained over the next few months.”

That last line is important – I think it means that if the labor market continues on its current pace through the rest of spring and into the summer (again, assessing the impact of fiscal contraction), then the tapering will begin in later summer or early fall.

In contrast, Minneapolis Federal Reserve President Narayana Kocherlakota argues that policy is still too restrictive:

The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

And, at a minimum, he would not favor reducing the pace of stimulus:

…this kind of analysis suggests that, currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.

I don’t think he would favor it in three months regardless of the labor data.

So many voices, so many views.  Looking through the noise, I think there is strong interest in tapering QE now that we have a string of job reports pointing to substantial and sustainable improvement in labor markets, but, given the fiscal contraction, little willingness to pull the trigger on tapering until we see another two or three similar reports.  On net, I think disinflation concerns will move to the back-burner as long as inflation expectations are stable.

Still, at the same time, the Fed wants to keep its options open, as they are very much cognizant that past efforts to pull back on easing have been premature.  Hence the talk that future moves could be up or down, which is really just plain confusing because why would the Fed even begin tapering if they thought there was a reasonable chance of having to reverse course the next month?  It is even more confusing given that some officials seem to care about inflation, but others labor markets. The former says more purchases, arguably the latter says less.  And I am not sure they have a consensus view of what would be the pace of tapering even if they all could agree on the forecast and relevant indicators. No wonder communications is a problem.  Back to Dudley:

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire. There is a risk is that market participants could overreact to any move in the process of normalization.

It seems that lacking a more clear, consistent framework for the exit from quantitative easing, the risk of miscommunication is high.  Hence, we are all looking toward today’s speech by Federal Reserve Chairman Ben Bernanke to provide the clarity that appears very much needed.

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