The Fed’s Non-Taper Is All About Credibility

September 18, 2013Danny Vinik 8 Comments

In a surprising move today, the Federal Reserve announced that it was not going to taper its bond-buying program. The Fed has been purchasing $85 billion worth of assets every month – $40 billion of mortgage-backed securities and $45 billion of long-term Treasuries. For months now, investors and journalists had expected the Fed to begin to decrease those amounts in today’s Federal Open Market Committee (FOMC) announcement. At 2 pm when the September FOMC statement came out, everyone was proven wrong:

However, the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month

The stock market, bonds and gold all soared on the news of continued easy money while the dollar crashed. Why was everyone so sure that the Fed was prepared to taper today? It all goes back to the June FOMC meeting when Chairman Ben Bernanke first hinted at tapering. The Fed also upgraded its economic forecasts and in the press conference, Bernanke repeatedly emphasized the improvement in the labor market.

“If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year,” Bernanke said. “And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”

Interest rates on the 10-year Treasury note skyrocketed while stocks and gold both fell. The market took it all to mean that easy money was coming to an end soon.

Except that wasn’t what Bernanke or the Fed was trying to say. They were trying to say that if economic data continues to come in positively, then the Fed will scale back its bond-buying program. But only if the economic data is good. From the June FOMC Statement:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

If you read it literally, that statement clearly indicates that the Fed will react to labor market conditions in determining whether or not to taper. But the market parses every single word Bernanke says and it soon became conventional wisdom that a taper was coming. Dallas Fed Bank President Richard Fisher and Minnesota Fed President Narayana Kocherlakota both tried to walk back Bernanke’s statement and assert that a taper was not necessarily coming.

It didn’t matter.

But today, the Fed proved everyone wrong who parsed the statement and everyone right who read it literally. Subsequent jobs reports have been underwhelming, the Fed reduced its economic forecast today and the federal government is threatening to blow up the economy. If you listened to all of Bernanke’s comments and read the FOMC statement without overthinking it, you wouldn’t have been surprised by today’s announcement. The Fed said it would only begin tapering if the underlying economic data improved. But it worsened so the Fed shouldn’t have been expected to reduce its bond-buying. Yet, journalists and investors alike assumed that the Fed was still set on tapering, despite the underwhelming economic data.

With its announcement, the Fed was not trying to correct anything Bernanke said. It was trying to correct the market’s blind reading of the Fed’s statements. “Don’t just read that we’re going to taper. Read the caveats as well and take them into account.” Markets had assumed that when Bernanke mentioned tapering, it was set in stone that it would begin today. They did not believe for a second that poor economic data could delay it. Despite attempts to walk back Bernanke’s comments, the Fed could not credibly convince investors that it was not necessarily going to taper in September. By surprising the market and adjusting its policy based on labor market conditions, the Fed regained its credibility today.

Senate Democrats Unnecessarily Force Summers Out

September 16, 2013Danny Vinik Leave a comment

Larry Summers is out of the running for chairman of the Federal Reserve after he notified the President yesterday “that any possible confirmation process for me would be acrimonious and would not serve the interests of the Federal Reserve, the Administration, or ultimately, the interests of the nation’s ongoing economic recovery.” Summers is right here. After Jon Tester (D-MT) announced Friday that he would vote against Summers in the Senate Banking Committee, it became clear that his confirmation process would be extremely difficult. His decision to bow out saves an ugly intraparty fight between the Administration and Senate Democrats. It was a fight that the President should’ve won, but wasn’t going to and Summers knew it.

To start, Obama should’ve nominated current Fed Vice-Chair Janet Yellen from the beginning. It should’ve been an easy decision. But the President loves Summers and was seemingly set on choosing him from the start. It wasn’t the optimal choice, but Summers would still have made an excellent Fed Chair. This is what makes it so absurd that Tester and other liberal Democrats were going to vote against him.

Larry Summers withdraws from the Fed Chair search.

Summers is, by all accounts, a brilliant economist. However, many liberals were wary of his prominent role in the repeal of Glass-Steagall and the deregulation of the derivatives market in the late ’90s. There’s no question that Summers was a leader in making those decisions, but Summers has also learned from them. He supports banks holding greater levels of capital, one of the focal points of Dodd-Frank. In addition, there’s not much information on Yellen’s regulatory beliefs. She’s an economist by trade, not a regulator. But skeptics of Summers inherently believe that she would be a tougher regulator than him. As Josh Barro pointed out on Twitter last night though, if Republicans thought that was true of Summers, they would’ve supported him as well. But that hasn’t happened either. The fact is that Summer would in all likelihood have implemented Dodd-Frank in a similar manner to how Yellen would.

Other arguments against Summers is that the nomination of an elite Democrat would politicize the Fed too much. But this argument is overblown. The Fed is already a politicized institution and nominating Yellen over Summers wouldn’t change that.

One of the least covered areas of this debate has been Yellen and Summers views on monetary policy. Yellen is considered more of a dove, but only slightly more. Markets perceive a larger difference between the two than may actually exist.

Finally, Yellen’s proponents argue that Obama has done a poor job appointing women to economic positions. This is true, but it’s not a strong enough reason to oppose Summers.

For all those reasons, Yellen is a better choice. But she’s only slightly better. Summers would still likely do an excellent job as Federal Reserve chairman. Both candidates should have had no problem receiving Democratic support. Instead, liberal Democrats jumped on this as a chance to fight the President. But why? This really does weaken Obama: he can’t even get his own party to support an extremely strong candidate in Summers. Does he have any sway on Capitol Hill at all? It’s increasingly looking like he doesn’t. This perceived weakness hurts not just Obama, but Democrats as a whole in trying to pass other legislation. A weak President is bad news the Democratic party.

This is why it was absurd for Democrats to vote against Summers. They may get a slightly better Fed Chair in Yellen (or maybe a worse one, if Obama nominates someone else) in return for showing that the President doesn’t even have sway in his own party. Does that sound like a smart move for Democratic senators and the Democratic party? It sure doesn’t to me.

Don’t Crush the Fed’s Independence

September 9, 2013Danny Vinik 1 Comment

Felix Salmon wrote a piece a little while ago arguing that President Obama’s nomination of Larry Summers to head the Federal Reserve would be the culmination of the politicization of the institution. He noted:

Make no mistake: Summers would be the most political Fed chair in living memory. Greenspan was pretty bad, especially when he testified — in clear support of the Bush administration’s tax cuts — that we had reason to be worried about budget surpluses. But Summers has been one of Obama’s closest economic advisers since the day that Obama took office: he’s much closer to Obama than Greenspan was to Bush.

Summers has spent most of the past five years doing everything in his power to shape and advance Obama’s agenda. Obama, of course, is very happy about this, and would love to reward Summers for his loyalty by handing him the Fed chairmanship.

…

That’s a move even Clinton would never have dared make: he kept Greenspan at the Fed for his whole presidency. And it sets a horrible precedent: the next Republican president will henceforth have no compunctions whatsoever about appointing a party hack to the post. From here on in, if Summers gets the job, we won’t just be voting for president in presidential elections. We’ll be voting for Fed chair, too. And the Fed will become just as politicized as the Supreme Court has become.

Salmon is being a bit overly dramatic here. While Obama’s nomination of Summers would be treated as a political appointment, it would also be the selection of a highly qualified economist who has extensive experience in and out of government. It wouldn’t be as good of a choice as Yellen. But it would still be pretty darn good. A Republican administration couldn’t nominate just anyone for the job. It would still have to be highly qualified candidate. And Mitt Romney’s rumored front-runners to take over for Ben Bernanke (Glenn Hubbard, John Taylor and Greg Mankiw) would have been equally as political Summers would be. Republicans are already working under the assumption that the Fed isn’t independent and we were already voting for a Fed Chair last November.

In a response to Salmon’s post, Slate’s Matt Yglesias commented that he doesn’t think this is a bad thing:

These are, however, both dysfunctions induced by the cult of central bank independence. A central bank chief who saw himself as a close political ally of the president, and recognized that poor macroeconomic performance would reflect poorly on the skills of his friends, colleagues, and protégés on the economic team, might be willing to put inflation paranoia aside. Even better, precisely as the Obama team apparently “worried” back in 2009, financial markets might believe he’d be willing to tolerate more inflation. That would be a de facto rate cut, and would boost the economy.

Of course, in the longer term, this strategy only works if the central bank chief really iswilling to overlook a bit of inflation in order to boost the economy. The belief that he’ll do it starts the cycle, but doesn’t end it. So the mere fact that people worry Larry Summers won’t be independent enough counts as a consideration in his favor. But to really seal the deal, he has to follow through and actually compromise the Fed’s inflation-fighting mission in order to help his friends in the White House.

I’m still not sold on the idea that he’s the best person for the job. But at the end of the day, Summers’ ties to the White House are a feature, not a bug. If Obama goes with him, as it looks like he will, let’s hope Summers doesn’t forget that he owes his position to a relatively narrow circle of friends that just so happens to include all the key economic decision-makers in the administration, and he owes them some favors.

This is a pretty scary post from Yglesias. Why not just make the Federal Reserve a cabinet in the government? There’s a very specific reason that the Fed is an independent institution: the best monetary and regulatory policies are not always in the best interest of the President and his administration. In the aftermath of the Great Recession, this has not been the case. Yglesias is right that the best thing Bernanke could have done was to allow for more inflation to spur on greater economic growth, which would’ve helped Obama stay in office. But that is just the case right now. It’s easy to think of counterexamples when a Federal Reserve chair too close to the President could lead to bad macroeconomic outcomes.

For instance, at times the Fed may have to raise interest rates to quash inflation, but this can induce a recession, which is certainly not in the President’s interest. This is what Fed Chair Paul Volcker accomplished in the late 1970s. Starting in 1977, the Fed started to raise interest rates, causing the economy to enter into a nasty recession. In 1980, President Jimmy Carter was defeated by Ronald Reagan, thanks in large part to the poor economy. The Volcker-induced recession may have cost Carter a second term (there were plenty of factors), but it tackled inflation. A less independent Fed may have been slower to raise rates to cut down on inflation. Is that something we want?

Or take regulation. New regulations impose compliance costs on companies. Many rules are created to prevent future crises. They hinder economic growth in the meantime, but are vital to the economy in the long-run. Yet, a less independent Fed Chair could feel pressure from the White House to implement looser financial regulations to spur on greater growth in the near-term and let a future president deal with the long-run costs. That sounds like a recipe for disaster as well. Thus, it’s incredibly important that we have an independent Federal Reserve.

If Obama nominates Summers, he won’t be selecting the best candidate for the job, but it will still be a very good one. It won’t be the culmination of the politicization of the Fed and that’s a good thing. It will be a strong choice and Summers will likely do a good job in the position. Let’s not blow this out of proportions.