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The FOMC statement released Thursday amounts to an extraordinary upgrade in the intensity of the Fed’s effort to ignite higher growth and reduce unemployment. The new “conditional” approach — call it CA — to monetary policy aims at enabling the Fed to affect real variables like the level of unemployment by pre committing it to further action if goals are not met and pre committing it to maintain a highly accommodative policy stance (zero interest rates and QE) even after the economy starts to improve.
The new approach has been hinted at for years in academic papers presented at the Fed’s annual Jackson Hole Conference and elsewhere. The new approach was forcefully expressed at this year’s conference in a paper presented by Michael Woodford, a former Princeton colleague of Chairman Bernanke, and the September 13 FOMC statement clearly reflects to influence of Woodford’s analysis. See “Methods of Policy Accommodation at the Interest-Rate Lower Bound” presented at the Jackson Hole Symposium August 31-September 1, 2012.
At first blush, the FOMC statement looks like just another round of QE when it calls for additional purchases of mortgage-backed securities at a pace of $40 billion per month while continuing with existing operation twist measures aimed at push down long term interest rates. But this time the commitment to continue QE in some form is open ended. The FOMC commits to closely monitoring economic and financial conditions and goes on to make an extraordinary open-ended commitment: “If the outlook for the labor market does not improve substantially. The committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases and employ its other policy tools as appropriate until such improvement it achieved in a context of price stability.”
There are three extraordinary things about this statement. First, the Fed is saying that its asset purchasing commitment and the use of “other policy tools” is open ended until the outlook for the labor market improves substantially. Second, no allowance is made for the possibility of failure, despite the fact that extensive asset purchases have so far not produced a substantial improvement in the outlook for labor markets. There is an assumption that there is some level of asset buying or use of other tools that will produce substantial improvement in the labor market. Third, there is ambiguity about the Fed’s response to a possible rise in inflation. Is the labor market to improve substantially without a sharp increase in inflation? Or is the suggestion that if inflation picks up, asset buying and other measures will stop? The answer is not clear from the opaque reference to “a context of price stability.”
There is more. The Fed also expects that the highly accommodative stance of monetary policy will be warranted for another three years or more — at least through mid 2015 — because it expects that such a stance should be maintained for a considerable time after the economic recovery strengthens. This is a bold commitment since once again the risk of allowing inflation momentum to rise in a recovering economy is essentially ignored. If the economy does pick up that will be good news for banks because the yield curve should steepen rapidly as real interest rates and expected inflation rise and push up longer term rates while the Fed continues to hold down short term rates. If the Fed continues to try to hold down long term rates while the economy is recovering, the risk of a sharp rise in inflation is enhanced.
The Fed has taken a bold step by hinting strongly that it will be slow to tighten once the economy recovers and by betting that tolerating signs of higher inflation for a bit longer won’t require a sharp reversal of accommodation to avoid embedding higher inflation expectations into nominal contracts including interest rates and wages. We are looking at “whatever it takes” monetary policy that may result in a much weaker dollar and higher gold and stock prices as the U.S. exports deflation (stronger foreign currencies) into a world of weak demand growth , including a slowing Chinese economy. Whatever the outcome, the range of possibilities is much greater than it was before the Fed’s bold statement.
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