The Fed Plays With Its Tools

Well I got most of this right, except for the change in forward guidance. Today the FOMC announced that the Fed will be purchasing more mortgage-backed securities, and expects to maintain the policy rate where it is for a longer period than previously announced.

In its press release, the FOMC first tells us what it is worried about:

The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

Here, both parts of the dual mandate are addressed. The Committee thinks they are missing on the low side on real economic activity. From their point of view, while things are improving, they are not improving quickly enough. What exactly would an appropriate rate of improvement be? The statement makes that clear - economic growth has to be proceeding at a sufficiently high rate so the there is "sustained improvement in labor market conditions." I think the right interpretation of that is that the Committee wants to see the unemployment rate decreasing and the employment/population ratio increasing.

The second element in the dual mandate is inflation, of course. Note that the FOMC does not speak to the current or past rate of inflation, but to what they anticipate it will be. In some economic models, the central bank should want to control the anticipated rate of inflation, and current and past inflation are bygones, but there are pitfalls in practice. The key problem is that the Fed gets to write its own performance review if it defines success in terms of what it forecasts. In this case, the Fed's forecasts are in this document, and the inflation component of those forecasts is very optimistic. The pce inflation rate is forecast to be lower than 2% out to the end of 2015. I'm not sure what generated that projection, other than wishful thinking. I can't see how it's consistent with the forward guidance in the current FOMC statement, but more on that later.

In the paragraph in the FOMC statement that details "QE3," the latest Fed asset-purchase program, the Committee first tells us what they think QE does:

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate,...

Thus, according to the FOMC, quantitative easing both increases inflation and real economic activity - the Committee thinks more QE will move us up the Phillips curve. The Phillips curve, if you hadn't noticed, seems to be at the core of current Fed religion.

The announced QE program is to be added on top of two previously-announced asset purchase policies. The first of these replaces maturing agency securities and mortgage-backed securities (MBS) that run off (because of prepayments and defaults) with more MBS. In the absence of other asset-purchase programs, that policy would hold constant the size of the Fed's balance sheet (in nominal terms) - i.e. the balance sheet would otherwise be shrinking, though at a fairly slow rate. The second policy is so-called "operation twist," which had been extended to the end of the year, involved swaps of short-maturity Treasury securities for long-maturity Treasuries, at the rate of about $45 billion per month. The newly announced program calls for purchases of MBS at the rate of $40 billion per month.

Given past Fed actions, this move is somewhat aggressive. An operation twist purchase of long-maturity Treasuries is roughly the same as purchasing the same dollar amount in MBS. The fact that the Fed is issuing reserves in the latter case rather than selling short-maturity Treasuries should not make much difference, and it should not matter much if the Fed purchases MBS, rather than Treasury bonds (though I know there are claims to the contrary - see this and this). So, roughly, what the Fed plans is $85 billion in asset purchases per month (as it points out in the statement), which is a little larger than QE2, which proceeded at the rate of about $75 billion per month.*

An interesting feature of QE3 is that it is open-ended. Assuming one thinks that QE is a good idea under the current circumstances (and I don't think it matters at all), this also seems like a good idea. In cases where Fed decisions concern only a target for the overnight rate, it is deemed useful for the FOMC to reconsider what it is doing at each FOMC meeting. Why not do that for asset purchases as well?

Of course, it's important that the Fed adopt a reasonable stopping rule for QE3. What is it?

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Consistent with typical central-banker vagueness, that leaves the FOMC a lot of wiggle room, but I take it that they want to see the unemployment rate falling and the employment/population ratio rising in line with what we might see in a "normal" recovery.

The Fed also threw some forward guidance into the mix, for good measure:

the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

The previous wording said "late 2014." At this point, I think the forward guidance is essentially meaningless. This is not a promise - it's just a forecast - and no one should think the Fed is actually confident about that forecast.

We should also be asking why the change in forward guidance did not go the other way. If the Fed is so confident about the effectiveness of QE, it should be shortening the period until "liftoff," not lengthening it.

*Corrected from an earlier version.