Friday, February 22, 2013

The Fed

We are at the point in the US economic cycle (inflation currently benign, but economic and financial conditions improving) when the minutes of the FOMC meetings are more interesting than the post-meeting statement.  We saw that in January with the release of the December minutes which spooked bond markets by hinting at the possibility of an earlier than expected end to QE3.

There were no surprises in the January minutes released this week, although the market has interpreted them as biased to the hawkish end of the spectrum.  My reading of them is there was something in there for both the doves and the hawks.  What we are seeing is an FOMC actively engaging in debate about the appropriateness of current policy settings and the risks around that.  The minutes reflect a discussion on the potential costs of quantitative easing including inflation risks, financial stability and the risk of capital losses.  That’s a healthy discussion especially when policy has entered the realm of the unconventional. 

Staff projections for near-term GDP growth were revised up, largely due to fiscal drag not being as restrictive as they had assumed.  That may be reversed in the next meeting depending on the quantum of the fiscal drag from the sequester. 

The minutes also reflect an ongoing discussion on where the growth rate of potential GDP currently sits.  Of course what matters for monetary policy is not so much the absolute level of economic growth but the rate of growth relative to potential GDP.  Our assumption since the GFC recession is that potential GDP growth is lower than it was previously in most developed economies (yes, New Zealand included) which means output gaps may not be as large as currently estimated.  So, that too is a healthy debate to have.

In general there was nothing in the minutes to change my view that the first change in US monetary policy settings will be a gradual phasing out of QE3 (i.e. a reduction in the quantum of QE), but the end of QE is a 2014 story.  The risk to that view is a sharper fall in the unemployment rate than currently anticipated or earlier than expected signs of rising inflationary pressure.  Board staff have also been asked to do more work on the risks of QE.  That being the case, any unfavourable reassessment of the risks of ongoing asset purchases will have implications for current policy settings.