The Fed’s Non-Taper Is All About Credibility

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.

John Taylor Espouses The Republican Line on…Everything

Stanford economics professor John Taylor has had a long career both in public service and in academia. The most well known monetary policy rule, the Taylor Rule, is named after him (he came up with it). The man is a big shot in the financial world.

But over the past couple of years, he’s hewed to the Republican Party line on both monetary and fiscal policy more and more. That was never more apparent than in today’s panel hosted at the National Press Club on rejuvenating America’s economy. Former CFTC Chairperson Sheila Bair and PIMCO Head Mohamed El-Erian also took part in the discussion, which covered a wide array of topics that the panelists mostly agreed upon.

All three advocated that the Fed begin to pull back its Quantitative Easing program, with Bair arguing doing so over a longer timeframe. But Taylor was the most adamant that Fed should pull out of those policies as quick as they can.

“I see no positive effect on rates from quantitative easing,” he said. “People really need to realize that we don’t know the impact of these policies. I see them as basically negative.”

Taylor also repeatedly complained about the weak economic growth. “I’m worried this recovery will never become a real recovery,” he said. He offered similar sentiments in a recent Wall Street Journal op-ed. In response, Money Monetarist (and Republican) Scott Sumner showed the inconsistency of Taylor’s remarks:

Taylor seems to think that growth has been too slow, complaining about only 2% RGDP growth in 2012.  That suggests that easier money is needed. But he also complains about QE, claiming it didn’t help the recovery. However the stock market responded very positively to rumors of QE, not once but three times.  That suggests QE boosts growth.

Like John Taylor, I’d like to see higher interest rates.  Unlike Taylor, I explicitly favor a more expansionary monetary policy.  I favor a higher NGDP target, which would raise long term Treasury bond yields.  He seems to favor higher interest rates via a tighter monetary policy boosting short rates (the liquidity effect.)  In my view that policy would depress long term bond yields to Japanese levels, as markets (correctly) expected a replay of the US in 1937, or Japan in 2000, or Japan in 2006, or the eurozone in 2011—4 attempts to raise short rates above zero—all premature, all 4 attempts failed.  They all drove aggregate demand and risk free long term interest rates even lower.

Taylor’s prefered policy has been repeated by Republicans ad nauseam. It’s the standard GOP line. But it isn’t right and it’s a shame that Taylor is buying into it.

The discussion also touched on fiscal issues, where Taylor continued to promote Republican policies. He advocated for reducing the budget deficit through entitlement reform, revenue neutral tax reform that broadens the base and reduces the top rate and corporate tax reform. He also lamented the uncertainty of current federal policies.

“One of the things we need to face up to is the huge increase in regulatory policies,” he said.

He then called for greater predictability of government actions. I’m more sympathetic to this view-point than most liberals, but it’s still overblown. Reducing uncertainty is a good idea. It’s not a magical cure that will unlock 5% GDP growth. What would unlock 5% GDP growth is an explicit NGDP target by the Fed. I’m sure Taylor wouldn’t support such a proposal, but it would accomplish his goal of bringing about a real recovery. Unfortunately, he’s too caught up repeating Republican lines about the worries of easy money to think about effective monetary policy.