Fed Update

The FOMC is meeting today and tomorrow. What is on its collective mind? There are two issues which are likely to be on the agenda relating, respectively, to the two legs of the Fed's current unconventional policy actions: quantitative easing and forward guidance.

Quantitative Easing
The Fed's "operation twist" will end at the end of this month. Recall that this asset swap program began in September 2011, and was extended in June of this year. The program involves sales of Treasury securities with remaining maturities of 3 years and less in exchange for Treasury securities with remaining maturities 6 years or more. Those swaps have been proceeding at a rate of $45 billion per month. Even if the Fed wanted to continue that program, it would not be feasible, as the short-term Treasury securities on the Fed's balance sheet are all but depleted.

Since September, the Fed has been purchasing $40 billion in mortgage-backed securities (MBS) per month - the "QE3" program. This is also an asset swap, but in this case a swap of reserves for MBS. QE3 is an open-ended program, which will continue under conditions stated, for example, in the last FOMC statement:

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.

My best guess is that the committee will not think of the new information received since the last meeting as indicating "substantial" improvement in the labor market, and they will be looking to keep their policy stance the "same" as it was at the last meeting. But they can't do that, as it's impossible to continue the twist asset swap. What's the next best thing? Well, if you believe that QE works to actually ease something, as the FOMC certainly does, then you should also think that there is little difference between swapping short Treasuries for long Treasuries and swapping reserves for long Treasuries. What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month. In terms of total purchases, that's a little larger than QE2, which involved purchases of about $75 billion per month (all Treasuries). The Fed could of course buy more than $40 billion in MBS per month, but that would signal a change, and they're not likely to do it (I'm not sure about the feasibility either - how big is that market?).

Some concerns:
1)The Treasury and the Fed are clearly thinking about debt management in completely different ways. As for example James Hamilton and David Beckworth have pointed out, the Treasury has been systematically increasing the average maturity of the outstanding government debt in the hands of the public, while the Fed is systematically reducing it. The Treasury might be thinking that it can save a huge amount on debt service in the future by, for example, locking in a 30-year borrowing rate of 2.84%. The Treasury seems to think it is looking after us by lengthening the average maturity of government debt, lowering borrowing costs, and presumably lowering our future tax burden. But the Fed thinks that we get more real economic activity (temporarily, permanently?) if the average maturity of government debt is lower. The Fed also thinks it is looking out for us. Maybe Ben Bernanke should walk down the street and try to sort this out with Tim Geithner (or his successor).
2)Short of a theory of QE - or more generally a serious theory of the term structure of interest rates - no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it's irrelevant, it doesn't do any harm. But if the FOMC thinks it works when it doesn't, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

Forward Guidance
This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. Until now, the FOMC's forward guidance statements have included a calendar date for "liftoff" - the date at which the Fed's policy rate (the interest rate on reserves currently, given the large stock of reserves outstanding) rises above 0.25%. The last FOMC statement says that date is "likely" to be mid-2015.

After living with calendar dates in the forward guidance language since August 2011, FOMC members now appear to think they are a bad idea. Why? The Fed generally likes the idea of forward guidance, as it is another tool the Fed thinks it can use when it is up against the zero lower bound. Support for the idea comes from New Keynesians - Woodford et al. - and New Keynesian models. But Woodford is on record as thinking that a calendar date is a bad idea. One may think that extending the liftoff date will be more accommodative, as this increases anticipated inflation and lowers the real rate of interest, but extending the liftoff date also conveys pessimism.

The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0. The argument for triggers is that a calendar date can lead to policy errors, or negates the intent of the policy. If the Fed commits to the calendar date, it risks waiting too long to tighten, or it tightens too soon. But if the Fed appears willing to move the calendar date in response to new information, the forward guidance becomes meaningless. With triggers, the FOMC can state the policy once, commit to it, and move forward.

Here are the problems with triggers:
(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it's pretty bad. It's hardly a sufficient statistic for everything the Fed should be concerned with.
(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this "unusual" circumstance, those same people will wonder what makes other circumstances "normal." Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

My overriding concern is that the Fed's unconventional policy moves - one on top of the other - are digging a deep hole that it will find it difficult to get out of. Of course, Ben Bernanke seems likely to leave at the end of his term in about a year's time, so it won't be his problem.