Normalizing Monetary Policy WILLIAM POOLE SENIOR FELLOW, CATO INSTITUTE
3 2 ND A N N U A L M O N E T A R Y A N D T R A D E CONFERENCE GLOBAL INTERDEPENDENCE CENTER AND DREXEL UNIVERSITY LEBOW COLLEGE OF BUSINESS GERRI C. LEBOW HALL, DREXEL UNIVERSITY 16 APRIL 2014
The Issues 2
ď‚— How does the Fed get its portfolio
back to a reasonable size? ď‚— How does the Fed return to pre-crisis
operating mode, more or less?
Fed Portfolio 3
Historically Low Interest Rates 4
Money-Market Interest Rates After 1831 5
Recognizing Reality
Weakest Economic Recovery Since WW II 6
Financial Conditions Today Odd in the Extreme 7
Why? Key fact is very slow recovery of business fixed investment. Investment depressed by fiscal policy uncertainty, both tax rates and spending, and regulation.
Why the Slow Recovery? Slow Nonresidential Fixed Investment 8
FOMC Job One 9
Communicate clearly to markets, politicians,
public that real, nonmonetary factors hindering complete recovery. Fed cannot fix disincentives that are slowing recovery in investment. Fed cannot fix growing labor market rigidities. Candid Fed discussion might help the case for reform. A candid Fed might reduce political pressure that may lead Fed to overstay monetary ease.
FOMC Job Two 10
Formulate internally, and convey externally,
a policy strategy emphasizing the medium term (3-5 years). Emphasize difference between the strategy
and policy actions within the strategy. Yellen must eliminate “loose lips”
communications missteps.
Two easy actions to improve predictability. 11
Announce that all policy actions will be
confined to regularly scheduled FOMC meetings, except in extreme cases. Adjust fed funds rate in 25 basis points
increments, except in extreme cases. These minor steps would help to set
appropriate tone for Fed dealings with the market.
FOMC Job Three: Portfolio Unwind 12
ď‚— Complete reduction by $10 billion per month
in Fed portfolio expansion. Having started, to do otherwise would only upset market expectations and muddle Fed intentions.
ď‚— Commit to let portfolio run off, starting Jan.
2015, by not reinvesting interest and maturing principal. This step is the least disruptive the Fed could take. Announce sooner rather than later, preferably at June FOMC mtg.
Commentary 13
Do I expect the FOMC to take these actions?
Unfortunately, NO, NO, a
thousand times NO. Janet Yellen has spoken eloquently about the
tragedy of long-term unemployment. She has never said much about the predictability of Fed policy.
FOMC Job Four: Forward Guidance 14
Stop before this effort causes more trouble. Understanding the accuracy of FOMC
participants economic projections. Implications of forecast inaccuracy for the
infamous dot diagram.
FOMC Projections March 2014 mtg. 15
FOMC Projections Uncertainty, Mar 2014 (From Minutes of Mtg 18-19 Mar. 2014) 16
Implications of Projections Uncertainty 17
Footnote to Table 2 above explains that
outcome expected to be within the +/- range 70 percent of the time. March 2014 projections for end of 2014: central tendency of FOMC participants for unemployment rate were 6.1 to 6.3 percent. The projection better expressed as 6.2 +/- 0.6 percent or 5.6 – 6.8 percent. Moreover, probability is 0.15 that U < 5.6 and probability 0.15 that U > 6.8.
Summary Projections for 2014 18
GDP growth 2.9 +/- 1.6 = 1.3 to 4.5. U rate 6.2 +/- 0.6 = 5.6 to 6.8. PCE inflation 1.5 +/- 0.9 = 0.6 to 2.4. These are 50% confidence ranges. Outcomes
beyond these certainly possible.
Monetary Policy Implications 19
Markets will react, because Fed will react, if
economy comes in materially above or below point forecast. Fed “forward guidance” w.r.t. future Fed policy setting pays too little attention to implications of projection errors. The FOMC’s dot diagram attracts great attention when released as part of projections materials. Next slide shows dot diagram released just before Yellen press conference last month.
The FOMC’s Dot Diagram 20
Dot Diagram Interpretation 21
All but one FOMC participant anticipated that
the target federal funds rate would still be at 0.25 percent at the end of 2014. That is the best guess given that the economy performs as indicated by the central tendency of the economic projections. The fed funds rate pr0jection ought to have a range of uncertainty attached to it. Doesn’t Fed transparency call for it to report standard errors of past fed funds rate projections?
Question for Janet Yellen 22
At the March press conference, an astute
journalist should have asked the question next page: This question still needs an answer. The fact that the Fed has not addressed the
question is a key failure of Fed communication.
Question for the Fed 23
ď‚— “Chair Yellen, in the material the FOMC
distributes routinely with the minutes, a table shows experience with errors in economic projections. Suppose that by this summer it appears that the economy is one standard error stronger than current point projections. That would increase the 2014 projection for GDP growth to 4.5 % and the unemployment rate in the fourth quarter to about 5.6 %.
Question, continued. 24
“A projection error of this size would not be
particularly large or unusual. Assuming that the Committee also revised up its economic projections for 2015 and 2016, how would these revisions likely affect the projections for the federal funds rate in the fourth quarter of this year?” This question and the Fed’s likely answer are of critical importance to the markets.
Market Turmoil Ahead? 25
Since the recovery started in June 2009, GDP
growth has been persistently below projection. For example, consider midpoint of projection made Nov 2011. Projection for 2012 = 2.7 Actual = 2.0 Projection for 2013 = 3.2 Actual = 2.6 Outcomes were about ½ standard error below projections. FOMC has not prepared markets for outcomes above projections.
Thanks 26
ď‚—For being a brilliant,
attentive audience.
Discussion 27
Questions? Disputes? Facts neglected?
(No rotten tomatoes, please.)