Written by Adam Whitehead, KeySignals.com
In Terminal Velocity (3) – The Pyramid Scheme[i], it was suggested that the Federal Reserve was adopting a new policy in which its balance sheet remains expanded indefinitely. Applying this thesis, tactical micro-economic policy tools will be deployed that give the Fed the flexibility to normalize interest rates, whilst providing specific monetary stimulus to sectors of the capital markets and economy. An expanded balance sheet can therefore be as consistent with rising interest rates, as it can with falling interest rates. It was said that:
“We will watch Jackson Hole closely this year, to see if this template becomes official global central banking dogma.”
Recent information, in the public domain, suggests that advanced preparations are being made for Jackson Hole. Michael Woodford was identified back in 2012[ii] at Jackson Hole, as the architect of a new development in central banking; that would introduce the policy tool of communication into the Fed’s tool box. Woodford’s thesis[iii] was that the benefits of QE have been undone by the implications of speculation on the timing of its reversal. This thesis has been recently articulated by Janet Yellen[iv]. It is clear that the credit transmission mechanism is broken; and that QE is being stored in financial assets, rather than flowing into economic growth in the real economy. Concern has been raised within the Fed of the dangers of speculative bubbles, that this flow of funds is creating. The bursting of these bubbles, could potentially occur at a time of weak economic activity; presenting the Fed with a dilemma. The Fed would then have to decide on whether to ease to address the weaker growth risk, faced with the knowledge that this easing will potentially create more bubbles.
Recent communications from the Fed, signal that the new policy identified in Terminal Velocity (3) is taking shape. The most recent FOMC Minutes[v] were of particular interest. The section entitled “Review of Efficacy and Costs of Asset Purchases”, was of specific importance. The highlighted quotes below, clearly indicate the Fed’s attention to bubbles:
The staff provided presentations covering the efficacy of the Federal Reserve’s asset purchases, the effects of the purchases on security market functioning, the ways in which asset purchases might amplify or reduce risks to financial stability, and the fiscal implications of purchases. In their discussion of this topic, meeting participants generally judged the macroeconomic benefits of the current purchase program to outweigh the likely costs and risks, but they agreed that an ongoing assessment of the benefits and costs was necessary. Pointing to academic and Federal Reserve staff research, most participants saw asset purchases as having a meaningful effect in easing financial conditions and so supporting economic growth. Some expressed the view that these effects had likely been stronger during the Federal Reserve’s initial large-scale asset purchases because that program also helped support market functioning during the financial crisis. Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently, as the easing of credit constraints allowed more borrowers to take advantage of lower interest rates. One participant emphasized the role of recent asset purchases in keeping inflation from declining further below the Committee’s longer-run goal. A few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly; however, a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy. It was noted that, in addition to the standard channels through which monetary policy affects the economy, asset purchases could help signal the Committee’s commitment to accommodative monetary policy, thereby making the forward guidance about the federal funds rate more effective. However, a few participants were not convinced of the benefits of asset purchases, stating that the effects on financial markets appeared to be short lived or that they saw little evidence of a significant macroeconomic effect. One participant suggested that the signaling effect of asset purchases may have been reduced by the adoption of threshold-based forward guidance. In general, reflecting the limited experience with large-scale asset purchases, participants recognized that estimates of the economic effects were necessarily imprecise and covered a wide range.
Participants generally agreed that asset purchases also have potential costs and risks. In particular, participants pointed to possible risks to the stability of the financial system, the functioning of particular financial markets, the smooth withdrawal of monetary accommodation when it eventually becomes appropriate, and the Federal Reserve’s net income. Their views on the practical importance of these risks varied, as did their prescriptions for mitigating them. Asset purchases were seen by some as having a potential to contribute to imbalances in financial markets and asset prices, which could undermine financial stability over time. Moreover, to the extent that asset purchases push down longer-term interest rates, they potentially expose financial markets to a rapid rise in those rates in the future, which could impose significant losses on some investors and intermediaries. Several participants suggested that enhanced supervision could serve to limit, at least to some extent, the increased risk-taking associated with a lengthy period of low long-term interest rates, and that effective policy communication or balance sheet management by the Committee could reduce the probability of excessively rapid increases in longer-term rates. It was also noted that the accommodative stance of policy could be supporting financial stability by returning the economy to a stable footing sooner than would otherwise be the case and perhaps by allowing borrowers to secure longer-term financing and thereby reduce funding risks; by contrast, curtailing asset purchases could slow the recovery and so extend the period of very low interest rates. Nevertheless, a number of participants remained concerned about the potential for financial stability risks to build. One consequence of asset purchases has been the increase in the Federal Reserve’s net income and its remittances to the Treasury, but those values were projected to decline, perhaps even to zero for a time, as the Committee eventually withdraws policy accommodation. Some participants were concerned that a substantial decline in remittances might lead to an adverse public reaction or potentially undermine Federal Reserve credibility or effectiveness. The possibility of such outcomes was seen as necessitating clear communications about the outlook for Federal Reserve net income. Several participants stated that such risks should not inhibit the Committee from pursuing its mandated objectives for inflation and employment. In any case, it was indicated that the fiscal benefits of a stronger economy would be much greater than any short-term fluctuations in remittances, and moreover, a couple of participants noted that cumulative remittances to the Treasury would likely be higher than would have been the case without any asset purchases. Some participants also were concerned that additional asset purchases could complicate the eventual firming of policy – for example, by impairing the Committee’s control over the federal funds rate. A few participants raised the possibility of an undesirable rise in inflation. However, others expressed confidence in the Committee’s exit tools and its resolve to keep inflation near its longer-run goal. Another exit-related concern was a possible adverse effect on market functioning from MBS sales during the normalization of the Federal Reserve’s balance sheet. Although the Committee’s asset purchases have had little apparent effect on securities market functioning to date, some participants felt that future asset sales could prove more challenging. In this regard, several participants noted that a decision by the Committee to hold its MBS to maturity instead of selling them would essentially eliminate this risk. A decision not to sell MBS, or to sell MBS only very slowly, would also mitigate some of the financial stability risks that could be associated with such sales as well as damp the decline in remittances to the Treasury at that time. Such a decision was also seen by some as a potential source of additional near-term policy accommodation. Overall, most meeting participants thought the risks and costs of additional asset purchases remained manageable, but also that continued close attention to these issues was warranted. A few participants noted that curtailing the purchase program was the most direct way to mitigate the costs and risks.
In light of their discussion of the benefits and costs of asset purchases, participants discussed their views on the appropriate course for the current asset purchase program. A few participants noted that they already viewed the costs as likely outweighing the benefits and so would like to bring the program to a close relatively soon. A few others saw the risks as increasing fairly quickly with the size of the Federal Reserve’s balance sheet and judged that the pace of purchases would likely need to be reduced before long. Many participants, including some of those who were focused on the increasing risks, expressed the view that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings, while a few participants suggested that economic conditions would likely justify continuing the program at its current pace at least until late in the year. A range of views was expressed regarding the economic and labor market conditions that would call for an adjustment in the pace of purchases. Many participants emphasized that any decision to reduce the pace of purchases should reflect both an improvement in their overall outlook for labor market conditions, as implied by a wide range of available indicators, and their confidence in the sustainability of that improvement. A couple of these participants noted that if progress toward the Committee’s economic goals were not maintained, the pace of purchases might appropriately be increased. A number of participants suggested that the Committee could change the mix of its policy tools if necessary to increase or maintain overall accommodation, including potentially adjusting its forward guidance or its balance sheet policies.
The bottom line is that the Fed is aware of the bubble-risks, however feels confident that it has a process in place to monitor and address them. Consequently, the Fed has the confidence to maintain an expanded balance sheet; even allowing it to shrink via asset expiry rather than sale. The Fed is clearly in it for the long-term.
Jeremy Stein[vi] and Eric Rosengren[vii] have done their bit to identify bubbles. Recently they were joined by Kocherlakota. Kocherlakota has just embraced the lowering of the Evans Rule 6.5% Unemployment Target for QE to 5.5%[viii]; which brings with it the greater risk of creating asset bubbles. He has therefore become a strong believer in the need to identify bubbles “ex-ante” rather than “ex-post”[ix]. Evans himself has recently come out in support of this lowering of the bar[x].
All these adjustments by the Fed members are however incremental at the margin, compared and contrasted with what Woodford is proposing to become doctrine at Jackson Hole. In fact, they can be looked at as preparing the way for what Woodford would like to see delivered by Bernanke. His speech at the London School of Economics, in late March, pulled no punches. His prognosis for mending the broken transmission mechanism has been summarized here[xi]:
Nominal GDP and inflation targeting could go hand-in-hand as part of a radical policy to stimulate the economy, according to professor Michael Woodford of Columbia University.
Woodford, speaking at the London Business School alongside Adair Turner, the head of the UK’s Financial Services Authority (FSA), advocated a monetary policy framework where central banks essentially set policy to achieve a designated nominal GDP (NGDP) level, subject to hitting a medium-term inflation target.
Under such a framework, he argued, a central bank could then support aggregate demand by purchasing government debt and enabling an immediate, one-off transfer of money to members of the public.
This commitment to an NGDP target, he explained, would cultivate the belief that incomes will rise in the future and ensure the fiscal transfer was spent, rather than saved.
This does not mean abandoning the inflation target, he insisted, as the NGDP path could be pursued alongside a medium-term inflation growth rate. He Said,
“The central bank would be filling in the existing details of what it does in the meantime.”
So that the implications of what Woodford was suggesting were not lost on the audience, he was paraphrased with emphasis by the UK Financial Service Authority’s Adair Turner:
Speaking on his last day at the FSA – which ceases to exist as of April 1 – Adair Turner once again argued in favour of considering overt monetary financing – or ‘helicopter money’ – as a policy option.
Taken at face value, the reader must assume that Ben’s Helicopter will be landing at Jackson Hole, later this year. The Bundesbank won’t be a passenger or co-pilot, which has obvious implications for the Eurozone and the ECB.
Some of our readers may remain incredulous and circumspect; however we remind them that the Kuroda Helicopter just landed on Mount Fuji; and this event was enormous in magnitude but soon accepted as commonplace. These are unprecedented times in central banking. In addition, the IMF[xii] and the WTO[xiii] are preparing public opinion to accept the Jackson Hole helicopter; so there is a common theme running in the global economy.
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Compared to the BOJ and the BOE, the Fed is a model of monetary probity; and is arguably behind the global curve on QE in the Developed World of central banking. Relatively speaking and given the Fed’s position in the global economy, American monetary policy is restrictive currently. Now that market consensus has concluded that the US Dollar is in a secular bull trend and that the US Economy is the global driver, there is far less risk associated with the Bernanke Helicopter. On the issues of Trade Wars, allegedly brought up by the BRICs; suffice it to say that in a secular Dollar bull trend, the prospect of US monetary easing is something that they would welcome to boost their flagging economies. What is required is a catalyst for the Helicopter; and the Eurozone, faced with the prospect of break-up, as the Germans refuse to pick up the tab for fiscal union without a global bank run, provides the lowest fruit on the tree to be picked this summer.
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For those readers who don’t think that Bernanke will get away with it, we would suggest that they take a closer look at the Gold market. Pundits have now called not only the top, but also a bear market in Gold[xiv]. This implies the end of QE. By the time the Helicopter lands at Jackson Hole, Bernanke will have nothing to fear from the Gold Bulls and what they have been implying about his stewardship of the Dollar’s value. The bear call will therefore become a correction call, after the weak and also some of the strong hands have been shaken out.
