Terminal Velocity “Goldilocks Economy and the Three Bear Markets”[i] developed the idea that QE has pulled growth from the future, creating unsustainable values in asset prices. The Federal Reserve is now facing the convergence point at which the financial markets suddenly realise that the growth that has been priced in for the future does not exist.
Having noted that financial markets like to believe in the story that recessions have been triggered by premature tightening of liquidity, the Fed is intent upon head-faking this trigger; and then using the consequences to roll out its strategy for a permanently enlarged balance sheet that regulates both the economy and the financial institutions. Just as price discovery is leading to the conclusion that there is no growth, the Fed commits to an expanded balance sheet with the option to increase its size. Having dialed down the growth profile at the last FOMC meeting, the Fed continues to present its case for an expanded balance sheet rather than the tightening which the bond bears seem to think is coming. The back-up in yields now threatens to stall the recovery. From the Fed’s perspective, interest rates and future expectations are too high.
The New York and San Francisco Fed were enlisted to nuance the Communication Policy and adjust interest rate expectations lower[ii]. A joint communication emphasized that:
“Communication about the beginning of Federal Funds Rate increases will have stronger effects than guidance about the end of asset purchases.”
This was reminiscent of Bill Dudley’s speech, which opined that the markets would overreact to the “Taper”[iii]. This joint communication advises students of the martial art of Fed policy to observe what the finger is pointing at rather than the finger itself. Currently the markets are focused on the finger indicating higher interest rates; and the Fed now intends to focus attention on the level of interest rates being indicated. “Communication” on the Fed Funds Rate, rather than “Guidance” on the “Taper”, is more important going forward. Currently the focus of attention is on the “Guidance”, so the Fed will refocus attention on the Fed Funds Rate. Said Fed Funds Rate is lower than is currently discounted. To get back to this lower rate, weaker growth and inflation data will be presented as justifications. The recent back-up in yields practically guarantees this weaker data; and hence the fall in yields.
Further supporting evidence has recently been supplied by the Philadelphia Fed.
The Philly Fed signaled that Fed economists have deftly adjusted their GDP expectations for the rest of 2013 lower[iv]. Growth disappears in late 2013 and then reappears in 2014. In practice, the “Taper” talk rise in yields has guaranteed the veracity of this forecast. The Fed will thus be judged to have called it right, therefore its monetary response with alacrity will also be well accepted. As observers get fooled into believing in the Fed’s omniscience on economic forecasts, so they will also be fooled into believing in the Fed’s policy omnipresence. Communication Policy thus becomes a self-fulfilling (and powerful) tool, rather than its current perception as the Fed shooting itself in the foot.
The Fed is therefore positioned to deliver a much easier monetary policy, if and when the weak economic data start to show up between now and the September FOMC meeting when the “Taper” will be announced. The Fed has also put itself beyond reproach by getting its forecasts right; so that Communication Policy has been enhanced.
All is not well in the Fed however. There are some members of the team who understand the way expectations and markets are being manipulated; and believe that this is being done for political reasons. In Terminal Velocity “Gatsbied”, the move by the Obama Administration to apply economic policy to the plight of the American Middle Class was observed[v]. Political grid-lock prevents this outcome; which leaves the Fed’s balance sheet as the only effective economic policy tool for this purpose. The nomination of Sarah Bloom Raskin to Treasury Vice Secretary, suggests that there is a cohort within the Fed that buys into this idea[vi]. The emergence of a cohort that vitiates against this tactic is being led by Charles Plosser[vii]. Plosser would like to see what he calls “Bright Lines” demarcating the boundaries between fiscal and monetary policy. One suspects that the battle over the next Fed Chair is at a critical phase for the Administration. The ensuing volatility and weakness in markets however guarantees that whoever occupies the Chair will already have policy dictated to them in advance. The belief in the need for a “Taper” has the potential to swiftly change to the need for more QE.