Friday, December 14, 2012

Merry Christmas from the Fed

This morning the US Federal Reserve announced an extension of its outright asset purchase programme to compensate for the end of “Operation Twist” at the end of the year. Operation twist was the process by which the Fed was purchasing $45 billion per month of long-dated Treasury’s, funded by sales of short-dated Treasury’s. That will be replaced by outright Treasury purchases of $45 billion a month which is in addition to the $40 billion per month of Mortgage Backed Securities announced in September. This was widely expected, as anything else would have been deemed a tightening in policy.

The more interesting point in the Fed’s statement this morning was the change in the forward guidance on interest rates from a time-specific indication to one tied to a real economic variable – the unemployment rate. The previous guidance indicated that exceptionally low interest rates would be warranted until mid-2015. Here’s the important paragraph:

“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.”


The Fed argues that the date-specific and unemployment rate guidance are consistent. That seems reasonable. The important innovation is that the Fed has now bought some flexibility into an approach that previously hinged on a specific date with an arguable degree of flexibility around it. Under that arrangement communication was always going to be a challenge, especially if economic (and more importantly inflation) indicators warranted an earlier move. The Fed has bought extra flexibility by also specifying it will look at additional measures of labour market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. (Isn’t that the way CONVENTIONAL monetary policy used to work???

This transparency and flexibility is essential for Fed communications in the future. As we move inevitably toward the need for some reduction in the degree of stimulus being provided to the economy, the Fed now has the appropriate guidance apparatus to manage future monetary policy expectations. That’s an essential and smart innovation, especially in a world of “new normal’s” where effective central bank communication and transparency will continue to be important.