"We're Flying Blind," Admits Federal Reserve President

Reality Check (Nov. 6, 2012)

Eric S. Rosengren, the president of the Boston Federal Reserve Bank, recently gave a speech at Babson College on November 1. That was a good place to give it. Founder Roger Babson in September, 1929, warned of a stock market crash. Wikipedia reports: "On September 5, 1929, he gave a speech saying, "Sooner or later a crash is coming, and it may be terrific." Later that day the stock market declined by about 3%. This became known as the "Babson Break". The Wall Street Crash of 1929 and the Great Depression soon followed."

Dr. Rosengren began:

Today I plan to highlight three main points about the economic outlook. I always like to emphasize that my remarks represent my views, not necessarily those of my colleagues on the Federal Open Market Committee or at the Board of Governors. A first point is this: while it is still early to gauge the full impact of the Federal Reserve's September monetary policy committee decision to begin an open-ended mortgage-backed security purchase program, the program has so far worked as expected. The initial response in financial markets was larger than many expected. Given that our conventional monetary tool, the fed funds rate, has hit its lower bound of zero, we have turned to unconventional monetary policy. By that I mean policy that attempts to affect long-term interest rates directly, via asset purchases, rather than indirectly by setting the short-term interest rate, as in conventional policy.

Translation: "Federal Reserve policy has not been working for three years. The FedFunds rate is just above zero. That is because commercial banks have $1.4 trillion at the FED in excess reserves. So, the FedFunds rate is just over zero. In the good old days, the FED pumped in money to get this rate down. These days, it stays down, no matter what FED policy is. So, we had to target another rate. Otherwise, the investing public would conclude that the FED is impotent -- kind of like the Bank of Japan has been since 1990."

Unconventional policy has affected financial markets much like movements of conventional policy would have. Our use of unconventional policy tools has led to lower longer-term interest rates; higher equity prices; and, in a peripheral by-product of lower U.S. rates, exchange-rate effects.

Translation: "Believe me. Rates fell. Here is the proof. On September 12, the 30-year T-bond rate was 2.92%. On September 13, the FOMC announced QE3. The rate went to 2.95% by the close of the day. It was at 3.09% On September 14. But ignore that. On November 1, it was 2.89%. See? It was way down: three one-hundredths of a percent.

"So, the policy had no measurable effect on long-term T-bond rates. But so what? We want you to think that we are on top of things, steering the economy in the right direction."

He bragged that the policy had goosed the bond market. It hadn't. He said that it goosed the stock market. For a while, yes.

Is it the FED's job to manipulate the stock market? It appears so. Otherwise, why take credit for it?

By further easing financial conditions, the Fed's actions appear to be providing additional stimulus to the household sector -- as witnessed recently by higher consumer confidence, and increases in purchases of interest-sensitive items such as new homes and cars.

What was the cause? How do we know? He was bluffing. For one thing, the FED's monetary base shrank for three weeks after the press release. In early November, it was still below what it was on September 13.

The FED president seemed unaware of all this. But he marched forward, oblivious.

Certainly, concerns about such issues as the looming "fiscal cliff" in the U.S. and slow growth in many developed countries do appear to be depressing business spending. Still, our actions are likely to spur faster economic growth than we would have had without this additional stimulus -- and, as you know, economic growth has been painfully slow.

This is a statement of Keynesian faith in the face of policies that have not produced much success in four years.

My second point is that the increased quantity of bank reserves that resulted from these unconventional monetary policy actions have not resulted in inflation above our 2 percent target.

Translation: "Banks are not lending. Businesses are not borrowing. The economy is stagnant. The M1 multiplier remains flat. So, consumer prices are flat. That is what economic stagnation does in recessions and weak recoveries."

The statement issued after our last policy meeting highlighted that we expect to continue the asset purchase program until the economy experiences significant improvement in labor market conditions. How forcefully and how long to pursue asset purchases is complicated -- by the uncertainty surrounding the effects of unconventional policies; by the usual difficulty in assessing progress toward our dual mandate (given the sometimes noisy signals of both inflationary pressure and labor market conditions); and by the reality that the amount of stimulus provided by our asset purchases depends in part on market participants' assessment of the likely size of the asset purchase program.

Translation: "We have no idea when these policies will reduce unemployment. Your guess is as good as ours. But we get paid for our guesses. You don't."

The last complication is the result of the open-ended asset purchase program, since it does not entail a fixed amount or duration of purchases; in this respect it is more like conventional policy in the past.

Translation: "This can go on for years. Who is to say how long?"

In fact, the decision of when to stop easing during a recovery is a complicated matter even in more normal times, when pursuing conventional monetary policy through changes in the federal funds rate.

Translation: "FedFunds manipulation rate no longer works. We are flying blind."

Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets than if inflation were not so subdued. My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.

Translation: "What will policy be after it hits 7.24%? Your guess is as good as ours."

I think of this number as a threshold, not as a trigger -- and the distinction is important. I think of a trigger as a set of conditions that necessarily imply a change in policy. A threshold, unlike a trigger, does not necessarily precipitate a change in policy.

Translation: "We will conduct a study. Yes, my friends, a study. Trust me."

Instead, I think of my proposed threshold as follows. Once the unemployment rate declines to this level, we would undertake a full assessment of labor market conditions and inflationary pressures to determine whether further asset purchases are consistent with the desired trajectory for reaching our inflation and unemployment mandates in the medium term. Thus, a threshold precipitates a discussion and a more thorough assessment of appropriate policy, versus a trigger which starts a change in policy.

Translation: "This may sound as though we don't know what we are doing. This is because we don't know what we are doing."

As an example, suppose we reach one's threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term. This hypothetical situation would not necessarily imply a change in policy stance, especially if inflation was projected to remain below target.

Translation: "What will it take to get unemployment down to 7.24%? A real growth rate of 3%, which we have not had since 2005. In short, a wing and a prayer."

Let me say also that an unemployment rate of 7.25 sounds high, but achieving an unemployment rate of 7.25 percent would require real GDP growth of roughly 3 percent for a year. That would be growth that is a full percentage point faster than the economy's so-called "potential" rate of growth, making this a challenge to achieve.

Translation: "'Challenge' means 'highly unlikely.'"

And as I noted, this is a threshold, not a trigger -- at the 7.25 percent threshold the assessment of continued asset purchases would commence. It is worth noting that a variety of factors outside the realm of monetary policy (for example demographics) affect how low unemployment can get without igniting inflationary pressures. But my own personal view is that if inflationary pressures remain muted, then labor market conditions would need to be more like 6.5 percent unemployment to warrant the federal funds rate being lifted off the zero bound.

Translation: "I speak in the passive voice -- 'lifted off the zero bound' -- because nobody knows how this will be done, so I'm not saying the FED will do it."

With that preview, let me say a bit about the economic context and outlook. We are in the third year of the recovery, and the economy has averaged close to 2 percent growth over that time, which is faster than many other advanced economies but too slow to return the nation to anything like full employment anytime soon.

Translation: "So, kids, you will not get decent jobs when you graduate. Sorry about that. Given the fact that your parents are shelling out almost $60,000 a year, they are dumber than dirt. But that's their problem, not mine."

To promote faster growth, with the hope of speeding up improvement in labor markets, the Federal Reserve announced additional monetary accommodation at our September 2012 policy meeting. Three key aspects of the announcement were the continuation of our approach to exchanging short-term securities for long-term securities through December (the maturity extension program), the plan to purchase $40 billion in mortgage-backed securities each month until significant improvement in labor markets is achieved, and the indication that short-term rates are expected to remain exceptionally low through mid-2015.

Translation: "So, for the next three years, a bunch of salaried bureaucrats will be in charge of the economy, trying to goose it into action."

The effect of policy on longer-term rates seems in turn to be having a positive impact on the economy. To affect growth in the economy, financial market movements need to encourage firms and households to adjust their behavior. Of course, while it remains too early to fully assess the effect of our September action, households appear to be reacting to the easing in financial conditions.

Translation: "We are flying blind."

While the household sector has been responding to monetary policy actions, the response by businesses has been more muted. Firms appear to be deferring decisions until they have better clarity on the U.S. fiscal situation and on the likely path of international economic conditions. However, a continued household sector rebound is likely to improve demand and business conditions, encouraging more business investment -- particularly once some of these downside risks and uncertainties are resolved.

Translation: "There will be good news sometime in 2015. Probably. We hope."

One of the concerns voiced about unconventional monetary policy is that expanding the Federal Reserve's balance sheet -- injecting large quantities of reserves into the banking system -- could be inflationary.

Translation: "There could be inflation when banks start lending, which they will -- maybe after 2015. Until then, no sweat."

In other words, the policy action is open-ended versus time-bound. Should the economy experience another shock -- say from a U.S. "fiscal cliff" situation or a shock from abroad, then we could lengthen the period of purchases or increase the amounts (or both). Similarly, favorable shocks would mean that we would purchase fewer securities. The open-ended approach is particularly useful to convey that monetary policy will serve as an "automatic stabilizer" should shocks occur -- one hopes at least mitigating possible shocks that could buffet the economy. I say "mitigating" because monetary policy would not necessarily be able to fully and immediately offset large shocks.

Translation: "We will continue to inflate. Count on it."

As with conventional monetary policy, decisions about the ideal timing for ending unconventional monetary stimulus require balancing a variety of considerations.

Translation: "We will pick and choose which ones we think will keep criticism from the public muted -- preferably, as muted as business growth is today."

No single variable perfectly captures the underlying rate of inflation, as the sharp differences between core and total PCE indicate. Similarly, no single variable perfectly captures conditions in the labor market -- for example, unemployment rates can fall because workers become discouraged and leave the labor force, or because of a rapid expansion in hiring.

Translation: "We will get to do whatever we please."

Even if there were single variables that fully captured labor market conditions and inflationary pressures, the future path of those variables would depend on a wide range of factors.

Translation: "Just try to pin us down!"

Furthermore, because we are far from our normal policies, we must acknowledge the uncertainty surrounding the efficacy of these policies, as well as our ability to execute a graceful exit from unconventional policy (that is, to return to conventional federal funds rate policy, and to reduce our large balance sheet to a size more consistent with a normally-functioning economy). Given the lack of historical experience in exiting such a large balance sheet, the possibility of unintended consequences should not be dismissed. We are very attuned to these concerns and are working to address them.

Translation: "As I said, we're flying blind."

In summary and conclusion, let me reiterate that household spending patterns are consistent with some improvement in the economy, and appear to be responding (as desired) to monetary policy accommodation. Nonetheless, abrupt fiscal austerity or adverse shocks from abroad could still overwhelm the nascent positives. Hurricane Sandy's effects could exact a toll on the fourth-quarter performance of the economy. In general, potential downside risks make an open-ended monetary policy particularly attractive, because policy can recalibrate in response to such shocks without starting up new programs.

Translation: "Really blind."

Certainly I hope that these risks will subside, and we will quickly see more improvement in the economy -- leading to a substantial improvement in labor markets and an early end to our asset purchase program.

Translation: "And we will all live happily ever after."