Forward Guidance Works!

I’ve argued repeatedly that the Fed does not have a communications problem. The problem lies with journalists and the market, which interpreted Ben Bernanke’s comments in June to mean that the Fed was set to taper no matter what. This interpretation caused interest rates on mortgages to rise in anticipation of the taper. But rising mortgage rates hurt the housing sector and reduce economic growth. The Fed took that into account along with some other below-average data and decided to forego tapering. Many journalists argued that the Fed miscommunicated its strategy in June, but that wasn’t the case. By misunderstanding the Fed, the market priced in a Septaper which forced the Fed to delay it.

This should have given Bernanke more credibility as Fed chairman. Instead of reducing the Fed’s bond buying without looking at the data, the Fed responded to weaker growth by delaying the taper. It should have been a sign to the market that the Fed really is data-dependent. Instead, most financial commentators argued that it was the Fed’s communication strategy that was at fault.

A month later and now there are signs that the message actually sunk in.  Here’s Neil Irwin:

This time five weeks ago, markets were ready and waiting for the Federal Reserve to begin its “taper,” the beginning of the end of its program of pumping billions of dollars into the economy by buying bonds.

Not only did Fed leaders elect to sit on their hands at that meeting; now the smart money thinks they won’t even start to slow their bond buying until this coming spring! That’s all the more remarkable given that there has been no radical shift in the tenor of economic data, just a series of mild disappointments, of which the September jobs report issued Tuesday morning was the latest example.

The market is listening to the data and basing their expectations of Fed policy on it! That’s exactly what Bernanke set out to accomplish with forward guidance. He wanted the market to have a good understanding of future Fed actions, but to do so, he had to outline a plan for how the Fed would act in the future. There was no set timeline for the taper given the uncertainty in the economy. That’s what he was saying in June, but he was also saying that if the economy continued growing at a moderate pace (which it hasn’t been), then the Fed would begin to taper its asset purchases. That was the baseline investors should use to predict Fed policy. If the data comes in above average, expect a greater reduction in bond purchases. If it comes in below average, expect those purchases continue for a longer period.

As Irwin writes, the (limited) economic data hasn’t been that much worse in the past month, but the expectations of Fed commentators have changed drastically. Those expectations are now aligned with the Fed’s intentions.

This is how forward guidance works.  I argued a little while ago that the real test of forward guidance would be how the market would react to underwhelming economic data. Here’s what I wrote:

If economic data continues to come in below expectations, the Fed will likely delay tapering yet again. Will the market realize that or will it once again blindly assume that the taper is coming? If the market does blindly assume that the Fed won’t adjust its policy, then the Fed must realize that forward guidance doesn’t work. Bernanke could not have made it more clear, both in his press conference and now by the action (or lack thereof) the Fed has taken, that the central bank is data-dependent. If the market has not learned by the next FOMC meeting, it’s never going to and the Fed must admit defeat.

Look what’s happened! Journalists and investors everywhere are pushing off when they expect the Fed to taper. This is the whole point of forward guidance. After the first government shutdown in 17 years, maybe it seems obvious that the market should assume that the Fed will keep up the pace of asset purchases into early next year (at least). But part of it is that Bernanke and the Fed laid out a roadmap for investors to follow depending on the underlying strength of the economy.

In that previous post, I lamented that forward guidance would be a failure if the market still expected a taper despite continued underwhelming economic data. Investors and journalists were never going to listen. But the opposite is true too. They are all reacting to the data and adjusting their expectations of Fed policy accordingly. That’s a new level of Fed credibility that didn’t exist a month ago and it’s a direct result of the Fed’s decision not to taper. It gave investors confidence in the future path of Fed policy.

That means forward guidance has been a major success.

Raising the Debt Ceiling Is Paying Our Bills

Rep. Andy Barr (R-KY) is confused:

President Barack Obama says we need to pay our bills. I agree. But raising our debt limit without reform is not paying our bills. It is asking China, bond holders and other creditors to pay our bills.

The president says we need to avert a default. I agree. But raising our debt limit without any reform is not averting default. It is merely postponing default. Instead of simply opening up a new credit card in our childrens’ name because we’ve maxed out all of our own, we must take responsibility and stop business as usual in Washington. We owe it to our children and grandchildren to end the spending spree and start making the tough choices that will finally force the government to live within its means.

Here’s how U.S. fiscal policy works: The federal government takes in a certain amount of money and spends a certain amount of money each year. Congress passed laws that dictate what people have to pay to the government and how much the government will spend. In the U.S., the federal government almost always spends more than it takes in. It makes up the difference by taking on debt, but the debt ceiling prevents us from taking on more debt. It doesn’t change how much we’re spending or taking in. When Congress refuses to pay the debt ceiling, it stops us from making up that gap. The amount we owe doesn’t change. We just aren’t paying our bills.

The part about China is particularly bad. Rep. Barr really thinks that raising the debt limit is us asking China to pay our bills? China’s decision to purchase Treasuries has nothing to do with helping the U.S. out. China makes its own fiscal policy decisions that it thinks is best for itself, not the United States.

Finally, raising the debt ceiling without reforms does nothing to our odds of a future default. In fact, the only reason there is a chance the U.S. breaches the debt limit in the future (and I don’t think there is one) is the Tea Party’s willingness to do so. In a sane world, Congress would abolish the debt ceiling and there would be zero chance of a U.S. default, but sadly we don’t live in a sane world. Raising the debt ceiling now only increases the odds of a future default in that it makes Tea Party Republicans even more anxious to commit economic suicide.

No, The Government Shutdown Didn’t Cost The Economy $24 Billion

Now that the government shutdown and debt ceiling brinksmanship are over, the media has turned to playing the blame-game and diagnosing how badly the fiscal fights hurt the economy. On Wednesday, right before the McConnell-Reid deal passed both houses, S&P estimated that “the shutdown has shaved at least 0.6% off of annualized fourth-quarter 2013 GDP growth, or taken $24 billion out of the economy.”

This number, $24 billion, has been repeated around the internet as representing the cost of the shutdown, but that’s wrong for two reasons.

First, S&P is calculating how much the shutdown hurt the economy in the 4th quarter, but does not add in any bounce-back effects that will happen in the first quarter of next year. Many of the federal workers who were furloughed had to reduce their spending and it will continue to have an effect into November and December. But they will receive pay for their missed time; eventually that money will circulate into the economy. That doesn’t mean there were no negative economic effects to furloughing federal workers. Many workers in other sectors depend on those workers to purchase goods and services and those workers will not receive back pay. But that $24 billion is overstated as it does not included the bounce back effect. At the beginning of the crisis, Macroeconomic Advisors estimated that a the furloughs caused by a two-week shutdown would reduce real GDP by 0.3% in the 4th quarter. However, it noted that most of that should be made up in the first half of next year, as happened in the 1995-1996 government shutdown.

Second, the Federal Reserve may have delayed tapering to offset some of the negative impact of the shutdown. The September FOMC meeting outlined those fears:

However, a number of others (FOMC members) pointed to heightened uncertainty about the course of federal fiscal policy over coming months, including the potential for a government shutdown or strains related to the debt ceiling debate, which posed downside risks to the economic outlook.

In his press conference, Ben Bernanke repeatedly emphasized that the fiscal fights in Washington would be a drag on the economy. It’s unclear whether the Fed would have begun tapering in September if there was not a potential government shutdown and debt ceiling fight lurking in the near-future. It might have delayed reducing its bond purchases anyways as the economy slowed. However, investors are already predicting that the Fed will likely continue delaying tapering until at least the spring of next year since the federal government may go through these fights again in January. If that’s the case, then the Fed almost certainly kept its policy more accommodative due to the shutdown, which offsets some of that $24 billion in negative economic costs.

None of this is to say that the shutdown wasn’t costly. It was. It caused needless suffering for many Americans and certainly hurt the economy. But it’s unlikely to have cost the economy $24 billion. Keep that in mind.