Monday, September 3, 2012

US monetary policy: after Jackson Hole

Fed Chairman Ben Bernanke’s speech at Jackson Hole made a more impassioned case for further easing than I had expected.  When the Fed Chairman talks of “grave concern” about the continued weakness of the labour market and the potential human and economic costs, further easing seems more likely than not. 

Of course this speech was not a policy announcement.  Setting monetary policy remains the purview of the Federal Open Market Committee (FOMC) which meets next on September 12/13th.  Bernanke was therefore careful to qualify his comments on further monetary policy action with the key phrase “as needed”.   That continues to leave the same questions as before: whether it will be needed, what options they have for easing and when it might happen?

Dealing with the options first, we know from earlier FOMC deliberations there are a number.  These include communication (such as forward guidance on interest rates); a cut in interest rates on excess reserves; a UK-type “funding for lending” program; or more asset purchases (quantitative easing).   Of course a package of any of the above is also possible.

Bernanke spent a large part of his speech addressing the cost/benefits trade-offs of quantitative easing.  He described the costs in some detail.  These include: possible impairment of market functioning; a reduction in public confidence in the Fed’s ability to exit smoothly from its accommodative polices at the appropriate time (i.e. a rise in inflation expectations); risks to financial stability; losses to the Fed if interest rates rise.  He argued, however, that quantitative easing has had a net positive effect on economic activity and employment.

I’d add another cost. As I’ve mentioned before, I think America’s economic (and labour market) woes warrant a broader policy response than just monetary policy.  Bernanke says as much in his conclusion: “...Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve...”.  I worry the more the Fed does the less action we are likely to see from other policymakers.

The “whether it will be needed” and “when” are linked.  The FOMC’s deliberations in two weeks time will focus on a number of things.  Firstly, the data news has improved since their last meeting in August, although not universally so.  Having said that, it appears economic growth has slipped to a new level of around 1.5% per annum from an apparent 2% previously.   There is more important data to come before the Committee next deliberates including the manufacturing ISM and labour market data for August.

Secondly, they need to consider what is driving the current weakness in the economy and what events are coming up that might turn some of that weakness around.  Key amongst those are concerns about the so-called “fiscal cliff” and what action may be about to be undertaken by the European Central Bank in Europe.  As I’ve mentioned before, much of the current weakness in global growth is due to Europe, either directly through trade flows or less directly through its impact on business and consumer confidence.  I think an easing of financial tension in Europe would have a more significant impact on business confidence globally than more easing by the Fed is likely to have on confidence in America.

That suggests to me that if the Fed is ready to do something at its September meeting, it will be at the less aggressive end of the spectrum, most likely via communication of its interest rate guidance.  We should also remember that the Fed is currently easing via the second tranche of “Operation Twist”, which isn’t scheduled to end until December.  Seems to me the Fed should keep its QE3 powder dry to see how things play out in Europe, have a better indication of the likely path of fiscal policy, and of course how the domestic data plays out.  Watch this space.