Federal Reserve Chairman Ben Bernanke
The Federal Reserve rang out the old year with fireworks, but the New Year could be just as explosive.
There can be little doubt that a majority of the Fed's policymaking Federal Open Market Committee (FOMC) member are fully prepared to expand its balance sheet even further than it already is planning to do in an effort to stimulate the still-sluggish economic recovery and reduce unemployment.
The one thing that could change that, of course, is a significant pick-up in growth and a realization of the "substantial" labor market improvement the FOMC has been seeking since it approved $40 billion per month of mortgage backed securities purchases in September.
But few forecasters, inside or outside the Fed, are looking for dramatic improvement on 2012's 2% growth pace or in the jobs picture. Fed officials, in their latest forecast, are projecting the unemployment rate will still be 7.4% to 7.7% at the end of 2012.
A resolution of the budgetary deadlock, as now seems likely, through higher taxes on "the rich," including many small businesses, might end much of the uncertainty that has dampened hiring and investment. But a tax jolt on producers with little meaningful spending restraint hardly seems a prescription for appreciably faster growth. Nucor CEO Dan DiMicco recently remarked that "the focus on higher taxes in the fiscal cliff negotiations almost guarantees another year of tepid growth."
Some Fed officials have grave doubt whether more doses of monetary stimulus can do much to boost real output or employment. "Employers will not deploy the cheap and abundant capital on hand toward job creation while there is so much uncertainty surrounding final demand for the goods and services they sell....," says Dallas Federal Reserve Bank President Richard Fisher. "Until they know what their taxes will be or how federal spending patterns that affect them and their customers will change (or, one might add, whether the nation will have a more rational regulatory structure), they will sit on their abundant money rather than spend it on unemployment-reducing expansion."
But that's not the predominant view, and the FOMC's policy statement and the comments of Fed Chairman Ben Bernanke at his post-FOMC news conference embody an unmistakable bias toward further easing.
December FOMC meetings have traditionally been rather staid affairs, but not this past one. Not wanting to compound the problems of the "fiscal cliff" with a monetary cliff, the FOMC fully replaced the $45 billion of expiring "Operation Twist" Treasury bond purchases, financed by sales of short-term Treasuries, with outright purchases of the same amount, financed by creation of new bank reserves.
Combined with the $40 billion monthly MBS purchases, the Fed will be doing $85 billion per month of "quantitative easing" — indefinitely. At that rate, the Fed's balance sheet will rise by a third to roughly $4 trillion this year.
And the Fed could do even more, judging from the signals Bernanke and company have been sending.
Consider that, before the December meeting, relatively moderate St. Louis Fed President James Bullard was arguing that only $25 billion of the $45 billion expiring Twist purchases should be replaced with outright Treasury purchases — for a total QE3 of $65 billion — if the FOMC wanted to keep monetary policy "on an even keel." Bullard, who will be an FOMC voter this year, maintained that a dollar for dollar replacement, would amount to an "easier" monetary policy.
Revealingly, though, Bernanke told reporters "the amount of stimulus is more or less the same" and that the FOMC action was just "a continuation of what we said in September." He contended it is essentially irrelevant whether the Fed is financing bond purchases with new money creation or through short-term sales.
By inference, if Bernanke does not think what the FOMC did in December constitutes an easing, that leaves room for additional easing in the future if he does not see "substantial" and "sustained" improvement in labor market conditions.
Other Bernanke comments pointed in the same direction.
The Fed chief stressed that the FOMC "intends to be flexible in varying the pace of securities purchases in response to information bearing on the outlook or the perceived benefits and costs of program."
True, Bernanke was somewhat symmetrical, saying that "if the economy's outlook gets notably stronger we would presumably begin to ramp down the level of purchases."
But throughout his news conference, he stressed the need to make "substantial" and "sustainable" progress in labor markets, which in turn would require faster economic growth. And he repeatedly warned of the potential economic damage from the fiscal cliff.
The Fed "couldn't fully offset" those negative effects, he said, but "on the margin we would try to do what we could. Perhaps we would increase a bit" the amount of quantitative easing. Noting the Fed has "innovated quite a bit in the last few years," Bernanke said, "it's always possible we can find ways to find support for the economy."
Bernanke acknowledged "there's no doubt that with interest rates near zero and with the balance sheet already large that the ability to provide additional accommodation is not unlimited," but he said "that actually is an argument for being more aggressive now." The need to accelerate growth and insulate the economy against shocks is "an argument for being somewhat more proactive now when we still have the ability to do that."
Also indicative of an easing bias is the way Bernanke continually downplayed inflation risks, confidently predicting inflation will stay "close to the Committee's 2% objective."
Whether or not he seeks to expand asset purchases, Bernanke made a point of emphasizing the Fed will maintain a very loose monetary policy longer than it has in past business cycles.
For instance, he said "a decision to end asset purchases, whenever that is reached, will not be a turn to tighter policy." While the Fed would "no longer be increasing policy accommodation," it "would remain highly supportive of growth."
"Only at some later point would the Committee begin removing accommodation through rate increases," he said.
The FOMC's revamped "forward guidance" on the path of the federal funds rate — replacing the mid-2015 calendar date with a set of economic thresholds for signaling how long it will keep the rate near zero – also bears importantly on the policy posture in the coming year and beyond.
The FOMC said it expects to keep the funds rate in a zero to 25 basis point range "at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2% longer-run goal, and longer-term inflation expectations continue to be well anchored."
Note, by the way, that the FOMC's numerical thresholds employ a contemporaneous reading on unemployment, but use an inflation forecast. Bernanke justified this approach on the grounds that the FOMC wanted to "make clear that it intends to look through purely transitory situations in inflation such as those induced by short-term variations in prices of internationally traded commodities and focus instead on the underlying inflation trend."
There's not much question that the asymmetric treatment of the inflation threshold biases policy toward using monetary stimulus to reduce unemployment.
And that's not all. Bernanke stressed that "reaching one of those thresholds will not automatically trigger immediate reduction in policy accommodation. If unemployment was to decline at a time inflation expectations were subdued and (expected) to remain so, the Committee might judge an immediate increase in the target for the federal funds rate to be inappropriate."
Bernanke said the FOMC "will follow a balanced approach in seeking to mitigate deviations of inflation from the longer run 2% goal and deviations of employment from the estimated maximum level."
Even more bluntly, he said unemployment "could be well less than 6.5% after the (funds rate) take off point." And he said, "Whenever that occurs it would be relatively gradual. I don't think we're looking at rapid increase."
The FOMC is assuming "an increase in the funds rate first occurring sometime after unemployment goes below 6.5% but doesn't necessarily assume rapid increase after that....," he said.
"We'll look at the situation. But, assuming inflation remains well controlled, which I fully expect, the increase in rates would be moderate...."
Bernanke called the 6.5% unemployment threshold merely "a guidepost in terms of when it is that the beginning of a reduction of accommodation could begin. It could be later than that, but ... no earlier than that time."
Essentially, the FOMC is willing to tolerate inflation up to 2.5% in an effort to lower unemployment, but is willing to keep policy easy even if the unemployment rate falls below 6.5% if inflation is deemed not to be a threat. If that's not an easing bias, what is it?
Chicago Fed President Charles Evans, an early proponent of numerical thresholds who will be an FOMC voter in 2013, has called the inflation threshold a "safeguard." But for others, it provides very little protection against inflation.
Richmond Fed President Jeffrey Lacker warns the unemployment and inflation thresholds "could well conflict" and could "tie our hands." If they had been in place in 1994, he says the FOMC could not have preemptively raised rates when it saw incipient signs of inflation pressures.
The so-called "safeguard" is really "an inadequate defense because it essentially requires that we lose a measure of credibility before it can be invoked," says Lacker.
And in fact, by using an inflation forecast, the FOMC has given itself an enormous out if it chooses to use it. If actual inflation rises to 2.5% or higher, while unemployment is still above 6.5%, the FOMC can rationalize maintaining an easy policy or even making it easier by projecting that inflation will come back below 2.5%.
You might say that, from the Fed's standpoint, the inflation "safeguard" has a safety valve.
