Post-FOMC: What Does the Fed Think It Is Up To?

I'll try to dissect the FOMC statement from yesterday.

The primary policy change is:

The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less.

While some people want to interpret this as different from QE2, which was a swap of $600 billion in reserves for long-maturity Treasury bonds over a period of about 8 months, a swap of short-maturity Treasury bonds for long-maturity Treasury bonds amounts to essentially the same thing under current conditions. The only differences are that the purchase is 2/3 of QE2, and takes place over a longer period of time.

While this asset swap was widely anticipated, the other policy change was not:

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

Since mid-2010, Fed policy had been to reinvest these principal payments in long Treasury bonds.

My contention is that both of these interventions are irrelevant, and will have no effect on current or future prices and real activity. First, as I argue here, the asset swaps cannot matter. Second, while the QE1 purchases of mortgage-backed securities (MBS) may have mattered (possibly in some bad ways), under current conditions MBS purchases by the Fed cannot make any difference unless the Fed purchases dominate the market, which they will not.

So what does the FOMC think it is doing? First, it justifies the interventions in terms of its dual mandate:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.

As we know, FOMC statements post-financial crisis now are much more explicit about the dual mandate, in including the "maximum employment" language. Further, note the emphasis on future inflation here. The FOMC is telling us that what matters is the Fed's forecast of future inflation (which is low) not current inflation (which is high). This is quite different from what we saw in Bernanke's justification for QE2:

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run.

Thus, in November 2010, Bernanke wanted to convince us that QE2 was reasonable by appealing to current inflation observations; now he wants to convince us based on the inflation rate that we have not yet seen. My interpretation of this is that he does not actually care that much about inflation, but is focused on the second part of the mandate (real activity), as Charles Evans (one of the members who voted for the policy) certainly is.

Now, an interesting part of Bernanke's Washington Post piece that justified QE2 was this:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Maybe Bernanke can explain to us why the Fed's announcement this time coincided with a large drop in stock prices and a narrowing of the spread between nominal Treasury bond yields and TIPS yields (the break-even inflation rate).

I am collecting a set of rules for central bankers. Here are some of them:

1. Don't claim credit for things you cannot control.
2. Don't claim property rights over things you cannot control.
3. Don't engage in interventions when you have no idea what the consequences are.

Bernanke and company have broken all three of those rules.

1. It is dangerous to claim credit for stock price appreciation.
2. The FOMC claims it is intervening to lower the unemployment rate. Under current conditions, it cannot do that.
3. The FOMC does not understand the effects of its policies.

Fisher, Plosser, and Kocherlakota are on the right side of the fence in dissenting on this decision, and I think we should support them.