Wednesday, December 18, 2013

FOMC Statement

Well the FOMC press release surprised me. The big news is that tapering (reduction in the rate of asset purchsases under the current QE program) will begin, with the rate of asset purchases decreasing from $85 billion per month to $75 billion per month - that's a reduction of $5 billion in purchases of long Treasuries, and $5 billion in MBS (mortgage-backed securities) purchases.

There's some different wording in the statement as well. For example:
The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.
So, the FOMC is telling us that it is concerned with the low rate of inflation. They're forecasting an increase in the inflation rate over time, to 2%, and if that doesn't happen, projected policy will change in some way. But how? There's some detail on that here (some of this language was in there before, but it may have changed somewhat):
The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. If incoming information broadly supports the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective, the Committee will likely reduce the pace of asset purchases in further measured steps at future meetings. However, asset purchases are not on a preset course, and the Committee's decisions about their pace will remain contingent on the Committee's outlook for the labor market and inflation as well as its assessment of the likely efficacy and costs of such purchases.
You have to take the part about asset purchases not being on a preset course with a grain of salt. That's what the FOMC told us when they began this current round of asset purchases, but the rate of asset purchases never changed, in spite of new information. Most importantly, note what the FOMC wants to do if inflation comes in below its forecast. That will imply more asset purchases, which will also mean that the liftoff date (policy interest rate above 0.25%) will be pushed further into the future. The Fed insists that QE and the overnight interest rate target are different instruments, and the two elements of policy are not related. That's clearly false. Those two instruments are part of the same policy package, determined by the same group of people.

So, less inflation than expected means "easier" policy. But my key point, in this and other posts, is that this is a trap for the Fed. As long as the policy rate stays close to zero, we should expect inflation to fall. In order to increase the inflation rate over the medium term, the policy rate has to rise. The nature of the trap is confirmed in this sentence:
The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal.

Other important information is in the Fed's new economic projections. This shows inflation increasing to 2% in the long haul, but still a little below 2% even in 2016. As well, the average forecast is for "firming," i.e. liftoff, in 2015. So, if ideas on the FOMC don't change, my prediction is that 2014 will be disappointing for the Fed on the inflation front - actual inflation will be less than what they're forecasting, and that will push firming/liftoff off into 2016. This will do nothing more than perpetuate the low-inflation trap.


  1. Please comment on why the establishment is unable to entertain alternative points of view like yours. Everyone continues to insist that the easy money has not worked because they have not done enough. Silly counterfactuals are provided to establish claims of success.

    1. Forging a consensus view on the FOMC is very difficult. Some people on the committee know a lot of economics; some don't know much. Over time, a working relationship has been built up (with members coming and going of course - but the institutional framework has a life of its own) around a very simple model of the economy. That's not a model an economist would write down - it's just a language that they speak at the FOMC meeting. According to the model, policy works this way: when we think there is slack in the economy, or inflation is low, we ease. When there is no slack and inflation is high, we tighten. Ease means the overnight interest rate target goes down; tighten means it goes up. That has worked tolerably well in the past - the committee can agree, and nothing too bad has happened in terms of economic performance. The problem now is that the "model" doesn't work in the current situation. Getting out of the trap is difficult because someone has to bring that whole committee to its senses. But that's difficult, as it's a committee of people with very different views and backgrounds.

    2. Alternative points of view? That monetary policy in a liquidity trap has small, insignificant or nonexistent effects on output is totally mainstream. No need for "alternative" stories (at least not the ones which are obviously nonsensical like 'expansionary monetary policy reduces inflation').

    3. Anonymous 5:33 AM, why do you even exist? Clearly you're serving no useful purpose.

    4. Funny how pointing out what mainstream macro says lures out the trolls. I guess a blog of an economist who claims that low rates lead to low inflation has to attract the loonies sooner or later. :D