The Fed’s Real Mistake: Tapering Too Soon

September 23, 2013Danny Vinik 1 Comment

Last week, I argued that the Federal Reserve had not made a communication error when it announced in its June FOMC statement that it would begin tapering later in the year if the economy continued to improve at a moderate pace. The problem was that the market did not listen to the Fed correctly. The Fed’s non-taper was not to correct a miscommunication. It was to correct the market’s misreading of that statement. That’s not to say that the Fed’s policies have been optimal. On the contrary, while the Fed did not make a mistake in its communication strategy, its’ making an even worse one in tapering prematurely.

When Ben Bernanke announced that the Fed was going to start a new round of quantitative easing (QE3), the unemployment rate stood at 8.1%. Today, it’s down to 7.3%, but this overstates the extent to which the economy has improved in that time. In particular, workers have dropped out of the labor market at an alarming rate, causing the unemployment rate to drop for the wrong reasons. Some of those workers are baby boomers retiring, but many more are simply people who are so discouraged that they give up looking for a job.

A better indicator of the state of the labor market is the employment-to-population ratio:

.
As you can see, the employment-to-population ratio crashed during the Great Recession as millions of workers lost their jobs. Since then, the economy has muddled along. It’s unlikely that we’ll return to a ratio of 63-64% anytime soon, because as the country gets older, we will have fewer working-age Americans. Nevertheless, the current rate of 58.6% is unacceptable. In June, the rate was 58.7%. Before that, the economy was certainly not growing at a quick enough pace for the Fed to begin reducing its pace of bond-buying.

That’s the Fed’s real mistake.

Bernanke should have announced that the Fed would continue its asset purchases until the economy showed substantial, consistent improvement. He should’ve said that the Fed always follows the unemployment rate closely, but would track a number of economic indicators. It would continue its unconventional monetary policy until either inflation began creeping upwards or the economy returned to full employment. In a perfect world, the Fed should implement NGDP targeting, but given that such a policy is not happening anytime soon, the Fed should focus on using its current unconventional policy to provide support for the economy. That means not reducing the rate of asset purchases when the economy is barely improving.

Except that is exactly what the Fed intends to do. That was what Bernanke announced in June. Unfortunately, economic growth over the past three months has been below the Fed’s forecast so it adjusted its policy and delayed tapering. But when the economy does improve more and the Fed decides to taper, it will make a big mistake. The Fed could correct its policy and decide to continue its bond-buying for a longer period of time until the economy grows stronger. But that would be an entirely different message than the one Bernanke delivered in June. Then, the miscommunication criticism would ring true.

However, there are no signs that this will be the case. Everything Bernanke said at this past press conference indicates that the Fed is ready to begin tapering once the economy grows at a slightly faster rate. It’s not a mistake of miscommunication. It’s a policy mistake. And since it’s going to hurt economic growth and weaken an already weak labor market, that’s a much worse mistake to make.

Everyone Is Misreading The Fed Again

September 20, 2013Danny Vinik 4 Comments

Well almost everyone. The conventional wisdom right now is that the Fed delayed tapering to fix its miscommunication in its June statement. The argument goes that the Fed should never have mentioned tapering and it was correcting itself by not cutting back its bond-buying. Here’s Bloomberg’s Justin Wolfers:

Chairman Ben Bernanke promised that future quantitative easing would depend on the incoming economic data. Those data clearly have been weaker than most analysts, including the Fed, had hoped. The only way for the Fed to convince markets that its policies are data-dependent is to make data-dependent decisions. Let’s hope this episode has helped rebuild some of the Fed’s credibility.

This whole taper debate is one that should never have happened. It’s the result of a failed communication strategy.

…

The point is that “taper off” doesn’t really represent an interesting new policy easing, but rather its main function is to undo the damaging tightening in financial conditions that occurred following the initial taper talk.

Wolfers analyzes the underlying situation correctly, but gets to the wrong conclusion. He says that the Fed is data-dependent and the economy worsened slightly over the three months in between the Fed’s June FOMC statement and its one two days ago. That should lead the market and investors to believe that the Fed would not taper, but it didn’t because none of them truly believed the Fed would adjust its policy based on the data.

The failed communications strategy wasn’t a Fed error. It was a forecaster error. I went back and read through the transcript of Bernanke’s June press conference last night. Every single time he mentioned tapering, he prefaced it by saying something like “if the incoming data support the view that the economy is able to sustain a reasonable cruising speed” or “[i]f the incoming data are broadly consistent with this forecast.” And guess what? The incoming data was NOT broadly consistent with this economic forecast.

This is where Tim Duy and I disagree. He writes:

I think this means that, in general, the data was broadly consistent with the Fed’s expectations. That is, we weren’t reading the data wrong. They just decided that they could wait until longer before initiating the taper.

The September FOMC statement did not do a good job of indicating that the data came in slightly below the Fed’s economic forecast. But Bernanke laid it out clearly in his prepared remarks:

in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction. Moreover, the Committee has some concern that the rapid tightening of financial conditions in recent months could have the effect of slowing growth, as I noted earlier, a concern that would be exacerbated if conditions tightened further. Finally, the extent of the effects of restrictive fiscal policies remains unclear, and upcoming fiscal debates may involve additional risks to financial markets and to the broader economy. In light of these uncertainties, the Committee decided to await more evidence that the recovery’s progress will be sustained before adjusting the pace of asset purchases.

The Chairman is saying two things here: (1) the rise in interest rates since June have already lead to a tightening in financial conditions and (2) the potential for a government shutdown/default makes the Fed cautious. Overall, the Fed reduced its economic growth forecast slightly. Bernanke is explicitly saying that the financial data is not consistent with their June economic forecast. The Fed is adjusting its policy as the state of the labor market changes.

That’s why I think Duy and other journalists are misreading the data. The job reports have been mediocre at best. The l abor force participation rate has declined. Average hourly earnings and average weekly hours have barely budged. The Commerce Department first revised its GDP numbers down from a 2.4% annual rate to one of 1.8% and then revised them back up to 2.5%. Mortgage rates have risen quite a bit. All of these are indicators of a barely growing economy, one growing slower than the Fed expected in June.

In particular, the rise in mortgage rates happened as a result of the Fed’s June FOMC statement. Slate’s Matt Yglesias writes that “[t]he punchline is that the tightening of financial conditions in recent months was caused by … rumors that the Fed was going to taper.” Except there weren’t any rumors. There was the June statement that explicitly repeated over and over again that the Fed would only taper if economic data was positive. The market read that to mean that the Fed was going to taper no matter what and interest rates rose. Because interest rates rose, the economic data worsened and the Fed followed through on its promise to adjust its policy based on the labor market. If the market had read the Fed correctly and not assumed the taper was coming, rates wouldn’t have risen as much and the Fed’s economic forecast would have been sunnier. That may not have been enough to overshadow the other mediocre economic data, but the market also wouldn’t have completely expected the Fed to scale back its bond-buying. The non-taper wouldn;t have been a shock. The Fed and market would’ve been in sync. Instead, the market’s blind assumption that the Fed wouldn’t react to the data forced the Fed to do just that. Bernanke’s remarks didn’t cause the tightening of financial conditions. The market’s misreading of them did.

Once again, journalists are misreading what the Fed is saying. Bernanke isn’t saying that he regrets mentioning tapering in June. He regrets that the market misread him. That’s what the Fed was trying to correct this week. It was trying to tell the markets that it really is going to listen to the underlying data. It was trying to regain its credibility by precisely adhering to the statement it laid out in June. But, no one is hearing that. Everyone is misreading the Fed yet again.

About That Farm Bill…

September 19, 2013Danny Vinik Leave a comment

Recently, everyone in Washington has been obsessing over the chance of a government shutdown and intraparty fighting between House Republicans and conservative Senators (Ted Cruz, Mike Lee, etc.). It’s been interesting to guess Speaker Boehner’s strategy – or lack thereof – and how Senate Republicans will act once they are put on the spot. But September 30 isn’t just when the government shuts down, it’s also when the current farm bill extension expires. That’s a big deal and it’s not getting the attention it deserves. Let’s recap what’s happened so far:

The Senate passed a $955 billion farm bill in early June by a 66-27 vote that included a $3.9 billion cut to food stamps.
.
In mid-June, House leadership suffered a surprising and embarrassing defeat when its farm bill failed by a 195-234 margin. Boehner and company had needed Democratic support to pass the bill – which cuts $20.5 billion from food stamps – as many conservatives didn’t think the cuts were severe enough, but a last-second amendment from Rep. Steve Southerland (R-FL) that Boehner allowed into the bill caused Democratic support to plummet.
.
In July, House leadership split the farm bill in two: one was all about agricultural policy and the other about food stamps. The House passed a farm bill without food stamps a a few days later, consisting of crop insurance, commodity and conservation programs and other small things by a 216-208 vote with no Democratic support.
.
Today, the House is taking up the food stamp part of the farm bill. This time the cuts are much bigger – $40 billion in total – and will attract few in any Democratic votes. The drastic cuts are expected to draw more Republican support so that the bill can pass.

That’s where we are right now. If the House passes that bill today as it’s expected to do – though it’s not a given – then the Senate and House would conference with all three bills and return a compromised version to each chamber where the two houses would vote again. If both pass, then it heads to the president’s desk. If anything goes wrong during that process and President Obama doesn’t sign a farm bill by September 30, then we would revert to a bill passed in 1949 and a bunch of strange, unknown things would happen. Basically, Congress can’t let that happen.

Let’s assume that today’s bill passes and the House and Senate head to committee. Liberals were already furious at $3.9 billion in cuts so they aren’t going to accept $40 billion. Certainly, both sides in committee can find a compromise between those two numbers. But Senate Democrats and House Republicans are both going to be highly reluctant to support $10-20 billion in food stamp cuts, albeit for opposite reasons. If such a bill comes out of committee, it will be very interesting to see who votes for it. Will Boehner have enough Republicans in the House? Will he have to break the Hastert Rule if the cuts aren’t that severe? Will Senate Majority Leader Harry Reid have trouble convincing his Democratic colleagues to support it? We could end up seeing a bill passed with a lot of moderate Republicans and Democrats in each chamber supporting the bill. That’s actually what a compromise looks like and both liberal and conservative activists will go home angry.

But a lot can go wrong here. House Republicans are already very wary of leadership throughout this budget fight and Senate Democrats could even filibuster the bill if enough of them are outraged by the cuts. The latter scenario is unlikely obviously, but not impossible. Public opinion doesn’t play much of a role in this since everyone is focused on the fiscal battles so neither side will necessarily take the blame. That also means that neither side has much incentive to compromise.

Once again, Democrats and Republicans are finding themselves far apart on a bill they have to pass. This could get very messy.