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Wednesday, February 20, 2013

FOMC Several - Many - Few - Some

It's that time of the month again. The market had pre-FOMC syndrome, and is now groping for the Advil as the anxiety cramps hit. Here's the relevant passage from the January FOMC minutes:
The Committee again discussed the possible benefits and costs of additional asset purchases. Most participants commented that the Committee's asset purchases had been effective in easing financial conditions and helping stimulate economic activity, and many pointed, in particular, to the support that low longer-term interest rates had provided to housing or consumer durable purchases. In addition, the Committee's highly accommodative policy was seen as helping keep inflation over the medium term closer to its longer-run goal of 2 percent than would otherwise have been the case. Policy was also aimed at improving the labor market outlook. In this regard, several participants stressed the economic and social costs of high unemployment, as well as the potential for negative effects on the economy's longer-term path of a prolonged period of underutilization of resources. However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy. A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets, although a couple of other participants noted that there had been little evidence to date of such effects. In light of this discussion, the staff was asked for additional analysis ahead of future meetings to support the Committee's ongoing assessment of the asset purchase program. 

Several participants emphasized that the Committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved. For example, one participant argued that purchases should vary incrementally from meeting to meeting in response to incoming information about the economy. A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred. Several others argued that the potential costs of reducing or ending asset purchases too soon were also significant, or that asset purchases should continue until a substantial improvement in the labor market outlook had occurred. A few participants noted examples of past instances in which policymakers had prematurely removed accommodation, with adverse effects on economic growth, employment, and price stability; they also stressed the importance of communicating the Committee's commitment to maintaining a highly accommodative stance of policy as long as warranted by economic conditions. In this regard, a number of participants discussed the possibility of providing monetary accommodation by holding securities for a longer period than envisioned in the Committee's exit principles, either as a supplement to, or a replacement for, asset purchases. 

Participants also discussed the economic thresholds in the Committee's forward guidance on the path of the federal funds rate. On the whole, participants judged that financial markets had adapted to the shift from date-based communication to guidance based on economic thresholds without difficulty, although a few participants stated that communications challenges remained. For example, one participant commented that some market participants appeared to have incorrectly interpreted the thresholds as triggers that, when reached, would necessarily lead to an immediate rise in the federal funds rate. A couple of participants noted that this policy tool would be more effective if the Committee were able to communicate a consensus expectation for the path of the federal funds rate after a threshold was crossed. One participant also indicated a preference for lowering the threshold for the unemployment rate as a means of providing additional accommodation.
 That was some discussion! There appears to be at least a significant minority that wants to end the 85 billion campaign no later than the end of summer. They probably have a number in mind of how deeply they want the Fed to get bogged down in these assets. 

But here's the thing - the Fed does not know what the federal government is going to do, and it does not know what the effect of the government's actions is going to be on the economy. Right now they have no other real tool, so it appears they will keep using this one. UGGH, Fed bang on economy with QE hammer!

My interpretation:
The earliest you can expect to see the program cut is probably July. It's a good bet it will be cut by September. I think the worried would like to start cutting slowly and sooner, because no one wants to take the stock trader's QE teddy bear away right before October, right? Not a good plan. 

The stated measurement goals have already been discounted in the minds of at least half the participants, and the argument is really now about how to get out gracefully, and without a market crash.

Because that's the real takeaway, and I think that's what's causing the nerves.The issue with the longer term losses was known to them all last year, and considered workable.  At least some of them have realized just how acutely dependent the stock market is upon their actions, and they don't know what to do about it.  And at least three of them are genuinely scared by this. One of the scared ones is willing to go hell-for-leather and put the bank into a future massive loss situation. I can guess who that one is. Several others are more confident and would just like to back slowly from the room, beginning as soon as possible, because they think they want to take their lumps while they are still small. 

A coalition is forming among the worried. 

The eventual compromise, providing no acute disasters in the interim, is going to be that the Fed sits on these assets. That will help them to avoid future losses. It does leave a lot of stimulus in the bag, and future inflation fighting is questionable.  

Here's what I don't understand:

What, exactly, do "capital losses" mean to an institution that can create its own reserves out of thin air? So they take a loss on the assets--is there some consequence to the Fed other than the implied tightening and the very real increase in rates?

And, if that's all they're worried about, why wouldn't they just hold the debt to maturity? Or heck, just declare jubilee for all it matters.

So while "currency wars" seem to be heating up, the Fed is getting hawkish?

I'm not saying it's wrong, I'm just saying I don't believe the hawkishness will stick. There is going to be a lot of political pressure put on to keep the presses going. There isn't going to be any political will to stop until price inflation becomes so obvious that cooking the CPI won't even matter.

With all the babble about sequestration, the so-called cuts barely amount to one month of QE at current rates.
I have a little different take. Woodford shows the way. He told the Fed at Jackson Hole that QE doesn't accomplish much but guidance does. The Fed took part of his advice and rolled out the "thresholds". Then goes Carney to BOE and talk of a "flexible" (euphemism for higher) inflation target. Then Abe wows everyone by saying he'll find himself a central banker that can commit to 2%.

So fast forward to Feb. The thresholds did nothing but goose stocks -- UE has flatlined. Meanwhile, an economist with a brain (Stein) points out the obvious: the Fed will have big losses on QE. So the logical next step is to follow Woodford/Carney/Abe and adopt a higher inflation target while downplaying QE. 3% or bust.
Bernanke, Yellen and Dudley are all that matter. Sorry. No dice MOM.
This reminds me of our current Fed Policy

Who is in charge of the clattering train?
The axles creak and the couplings strain,
and the pace is hot and the points are near,
and sleep hath deadened the driver's ear,
and the signals flash through the night in vain,
for death is in charge of the clattering train
We have plenty of inflation at the bottom end - food, fuel, the basics - but that doesn't count for the policy makers. They want to see inflation in end products, not inputs, and that's precisely the last place they will see it. Companies outside of the necessities do not have pricing power, so instead of raising prices they will cut costs. Hence QE results in no appreciable reduction in unemployment but does a wonderful job of lowering the standard of living, especially for the lowest income brackets.
There's NWIH that the Fed stops. They may not be making things better, but they're definitely keeping up morale. No way they step aside and watch stocks & bonds crater.

As they say, it's not the stock (i.e. balance sheet), it's the flow (purchases) that matters. Stopping purchases is akin to withdrawing life support and they don't have the cojones to do it.

p.s.: The fight over sequestration is symbolism over substance -- too little, too late to matter -- therefore they'll probably happen just so Republicans don't lose the ignorant faithful altogether.
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