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.

Is Another Round of Quantitative Easing Coming?

Today was a special Jobs Day Tuesday as the Bureau of Labor Statistics released the September jobs report, which had been delayed due to the government shutdown. It wasn’t very good. Total non-farm payrolls increased by 148,000, which was less than the expected 180,000, while the unemployment rate dropped from 7.3% to 7.2%. The labor force participation rate remained unchanged at 63.2%. The July (-15,000) an August (+24,000) revisions combined for an increase of 9,000 jobs.This report was disappointing, but what’s even scarier is the trend lines.

Here’s the three-month moving average going back to the end of 2011:

3 month moving averageThere’s a pretty good chance that something is wrong with the way the BLS seasonally adjusts the numbers. Every winter has been much better than the following summer, but the trend is still not good. We’re into Obama’s second term and the economy is still barely growing. The reasons for this aren’t clear, but the government likely has a lot to do with it. Sequestration is terrible policy that is taking a chunk out of the economy at the wrong time. Austerity is the last thing we need right now. The expiration of the payroll tax cut at the start of this year is likely having some effect as well. And, of course, shutting down the government and risking a default is about as boneheaded as it gets. Instead of constructing policies looking to get the economy back going, the federal government (read: Republicans) have stood in its way.

The Federal Reserve has been concerned about fiscal policy and chairman Ben Bernanke has repeatedly emphasized that Congress needs to do more. Except that’s never going to happen. The question then is will the Fed do more? The economy is slowing down, not recovering. The FOMC had hinted at tapering in September, but pushed it off due to weak data and the impending fiscal fights. The market had assumed that the Fed was going to reduce its bond purchases regardless of the underlying data. By delaying the taper, the central bank attempted to regain its credibility and prove to investors that it’s data-dependent. Now, this is another test of that credibility.

This was a bad report and the economy is trending downwards. More fiscal fights loom and sequestration will be worse in 2014 than it was this year. Inflation is still running well below the Fed’s 2% target. If the Fed is really data-dependent, it will seriously think about making its policy even more accommodative either through QE4 or another mechanism.. The economy is no longer improving at a moderate pace. It’s slowing and there’s no chance that fiscal policy will help. It’s time for the Fed to pick up the slack.

The Fed’s Real Mistake: Tapering Too Soon

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:

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.