AS MY colleague notes, the Federal Reserve surprised many of us yesterday by deciding to maintain its current pace of asset purchases, at $85 billion per month, rather than "taper". Ben Bernanke, the chairman, also made a number of interesting remarks that push policy in a decidedly more dovish direction. All in all it was a complex policy decision, and it's worth going through it piece by piece.
The Fed is quite clearly attempting to balance a number of perceived risks. The first and most important is the state of the labour market. At the time that the Fed began its taper talk the economy, according to initial reports from the Bureau of Labour Statistics, was consistently adding jobs at a rate of about 200,000 per month. That seems to be a pace the Fed can live with. But subsequent BLS reports revised down spring job gains and showed much weaker hiring over the summer. The unemployment rate continued to fall, thanks to reductions in the labour-force participation rate. As Mr Bernanke indicated yesterday, the Fed sees the unemployment rate as an incomplete measure of labour-market health.
It has therefore reacted to weakening job growth despite its earlier use of unemployment-rate thresholds as guideposts. Guidance that QE3 would be complete roughly when the unemployment rate touches 7% seems to have gone completely by the boards. This will no doubt lead many to argue that the Fed is squandering its credibility. But I'd argue it's healthy for the Fed to be comfortable backing off guidance which isn't leading to achievement of the dual mandate. (Indeed, I'd prefer the Fed to do less signalling about intermediate steps and more to emphasise that it will do whatever it has to in order to get unemployment down to "normal" levels and inflation back to target, at the least.
Along those lines, Mr Bernanke made two additional statements that intrigued me. one was that while the Fed has declared that rates will stay low until unemployment is down to at least 6.5%, it may in fact leave rates low as unemployment falls well below that figure, so long as inflation remains in check. That strikes me as a very useful development. The goal should be to orient expectations around achievement of the dual mandate, and so linking policy changes to a figure that is well above the Fed's estimates of full employment was an odd decision. Second, in response to a question from our own Greg Ip, Mr Bernanke mused that an inflation floor might be a useful thing to add to forward guidance. Depending on where the floor is set that could be an extraordinarily important development. The big failing of forward guidance so far has been that it is entirely consistent with continued stagnation: saying rates will stay low until a particular unemployment threshold is met does not rule out stagnation, high unemployment, and low rates forever (see Japan). An inflation floor, if set high enough, changes that by demanding additional action if the economy is not on pace to close the gap. A temporary inflation floor of 2.5% would be a very powerful tool.
Yet while Mr Bernanke was willing to make tweaks to the present framework, he, and the rest of the Federal Open Market Committee, are mildly constrained by the impending change in Fed leadership. I do think one of the forces pushing for continuity in this meeting was the desire not to change too much before the new chair arrives in January. Had conditions been dramatically different, they might have tapered anyway, but as things stood a holding pattern was the easy call. I wonder, however, whether Mr Bernanke's slight edits to the Fed's forward guidance don't reflect a broader view that forward guidance needs to be improved and strengthened to achieve the Fed's goals. His words make me mildly optimistic that when the new chair does arrive we can expect more progress on that front.
Improved forward guidance is surely desirable to the Fed thanks to a third concern: that the risk/reward trade-off to QE is not particularly attractive and getting worse. Several members of the Fed have long been worried that financial-market distortions may result from the policy. The gyrations in markets that resulted from taper talk no doubt reinforced this view. The Fed did reckon that those gyrations, and the rise in bond yields in particular, were dangerous enough to require dampening—through the choice not to taper. But I think the Fed wants to secure the labour-market recovery as soon as it can, the better to safely move away from QE. (In my view, the risks of the policy are overstated—emerging-market financial swings have been jarring but not, on the whole, that harmful, for instance—but I don't have an FOMC vote, and I'm not subject to the constant criticism that the Fed is looking to boost the economy by inflating new bubbles.)
Then there is a fourth constraint. The Fed moved surprisingly aggressively last December, in part because it worried that the "fiscal cliff" could seriously harm the American economy. once again Congress' inept policy-making has influenced monetary policy. With a government shutdown looming, easing of sequestration seemingly off the table, and a debt-limit fiasco not outside the realm of possibility, the Fed has determined that better-safe-than-sorry is the right way to proceed for now.
On net, it was an encouraging meeting. I wish the Fed were better at using expectations to its advantage. The decision not to taper would have been more powerful had the central bank not simultaneously warned of trouble ahead and revised its forecasts downward. That communicates that the Fed is doing more than anticipated because the economy will be weaker than anticipated, which in turn suggests that markets should not behave in a fashion that would accelerate the recovery.
Yet the Fed also took useful steps in the right direction. The cure for much of what ails the economy is full employment, and full employment is what the Fed needs to focus on achieving. Full employment will perk up wage growth, which is the inflation America really needs. At present, nominal wage growth is just a shade above 2%. That is about half what labour markets managed at full employment during the last two recoveries, and the Fed ought to allow for catch-up growth after the abysmal wage performance of the past few years. A period of strong wage growth will be all the sign the Fed needs that it is safe to allow rates to rise: safe, in the sense that disinflationary pressures won't immediately return. The return of strong wage growth should help bring re-employable workers back into the labour force, and it will communicate to policy-makers a fairly clear indication of where the natural rate of unemployment presently resides.
Given the Fed's past behaviour I still expect it to tighten policy too soon. Yet yesterday's meeting made me marginally more hopeful that it might not. What seems clear is that the first few months of the next chair's tenure will be of critical importance.
The Economist_Monetary policy_ Septaper surprise.pdf
