Thursday, September 19, 2013


The important news, of course, in the FOMC statement from yesterday is that there will be no tapering yet. Somehow, this came as a surprise to financial market participants, apparently, and I'm not sure why. There was essentially no news in the last employment report (more of the same, essentially), and rumblings on Capitol Hill are making people nervous about fiscal policy, so in terms of how the FOMC members think, the news is a little on the negative side. Given the reluctance to begin reductions in the rate of asset purchases at the last meeting, why would the Fed want to start now?

A piece of new language in the FOMC statement is this:
The Committee sees the downside risks to the outlook for the economy and the labor market as having diminished, on net, since last fall, but the tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market.
That "tightening in financial conditions" is the increase in bond yields (nominal and real) that has occurred since May, which is attributed mainly to how financial market participants have interpreted public statements by Fed officials - Bernanke in particular. The language in the statement might appear puzzling, if you thought that the increase in bond yields, brought on by the Fed, was part of their intention. It appears that the tightening financial conditions were unexpected from the Fed's point of view, so the postponement of tapering is in part an attempt to cool this down somewhat.

Unless we expect real rates of return on safe assets to remain low indefinitely, the Fed will sooner or later have to start increasing its policy rate (whatever that rate may be in the future). If it wants to be consistent with the policies that got the Fed's balance sheet into its current state, the rate of asset purchases will have to be reduced to zero before "liftoff" (an increase in the policy rate above 0.25%) occurs. Of course, it's not out of the question that, in unusual circumstances (an unexpected spurt in real GDP growth or inflation) liftoff could occur before tapering is done.

One possible complication in the Fed's exit plan is the upcoming change in leadership. With Larry Summers out of the running, chances are that Janet Yellen is the new Chair, in which case the timing of asset purchases does not really matter. If Yellen is nominated soon, chances are that tapering begins after the December FOMC meeting, which is followed by a press conference (no press conference after the October meeting). But, if Obama nominates someone else, then there are difficulties with committing to a tapering program before the new Chair is in place. However the first meeting post-Bernanke will be in March, and the current FOMC may think that is too far off. Once tapering begins, asset purchases will likely be reduced by about $10 billion a month, but possibly more if tapering begins later.


  1. Many of my friends in academia and in financial markets argue that changes in the pace of purchases should not have an important effect in financial markets (and hence would have no eventual effect on the real economy either). However, the empirical evidence from these two episodes provides striking confirmation that changes in the expected pace of purchases act just like conventional monetary policy."


    1. Yes, I'm very familiar with that argument. I guess the evidence does not "strike" me in the same way it strikes Jim.

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