Fed: Declare Victory and Go Home

Matthew C. Klein in a opinion piece on Bloomberg noted some of the discontents with Quantitative Easing (QE). He discusses some of the presentations at the Jackson Hole central banking confab, and how there is increasing concerns about the distributional effects of monetary policy.

Since any policy that affects the economy is going to have some sort of distributional effect, I do not see any way around that problem. The best you can hope for is understanding what is the impact of a policy, and then policymakers and voters have to decide whether it is in the national interest.

However, what struck me as interesting is this comment within the piece:

 Two weeks ago, the San Francisco Fed published a new paper refuting their earlier study. (Go figure.) Nowadays, the thinking is that asset purchases don't matter. The latest thinking is that the real punch comes from the Fed's so-called forward guidance on the future path of short-term interest rates. This is because long-term interest rates are always roughly equal to the weighted average of expected future short-term rates. Central banks can therefore reduce the cost of borrowing by promising to keep short-term rates lower for longer. At least, that's the theory.

Apparently the new thinking in monetary economics is catching up to what I wrote about rate expectations. More seriously, it appears the consensus is coming around to abandoning QE as a policy tool. As the referenced Fed paper argues, the policy has had negligible impact on the real economy*, which is exactly the impact QE had in Japan. However, it has the defect of driving the Tea Party wing of the Republican party into a frenzy. Since the Fed's primary political goal is to retain its independence, it is a bad idea to become a target of one party within a two-party political system.

However, having hitched their wagon to the QE horse, the problem for Fed policymakers is how to discontinue the policy without admitting they made an error. It will be easier with a new Fed chairman, but there were a lot of people involved in the decision. It seems the best option is to declare victory and go home: announce that the economy was saved by QE, but there are distributional effects (or it creates speculation, or whatever), and so the policy has to be discontinued - slowly.

It is unclear how fast the Fed will back away from QE, but if they do taper the rate of purchases by $15 billion a month at each meeting (which is the number starting to float around in market chatter), they are stuck with the policy until mid-2014.

It may be that the Fed could unwind QE more rapidly; for example by $30-$40 billion per month. However, they let the markets fixate on a slower pace, and it seems to late to change those expectations now. They already did a good job of blowing up the rates market in the last couple of months; given the stability of inflation and the steadiness in the decline of the unemployment rate, there seems to be little need to push the curve up higher at this point.

With the distraction of QE is out of the way, the Fed can return to a pure interest rate targeting once again. This puts us back where we started. One could hope this episode may have put a stake through the heart of the Money  Multiplier, but that seems to be a rather optimistic assessment of the ability of empirical results to influence economic doctrines.

* As a qualifier on my "negligible impact on the economy" remark, I accept that lower mortgage rates provided stimulus to that sector (at the cost of reducing interest income for other sectors). That said, lower mortgage rates are easily achieved via dropping rates expectations. Since the U.S.  economy has been feeble, those lower rates expectations may have occurred even in the absence of QE.

(c) Brian Romanchuk 2013