Macro and Markets

The first move is the hardest. The Federal Reserve defied expectations and did not reduce, or taper, its purchases of Treasury and MBS securities today, leaving them at $85 billion per month.  The economic projections accompanying the statement suggest a significant divergence of views about the prospects for recovery and the outlook for interest rates.  It suggests little concern about a rapidly increasing balance sheet.  What comes next depends on the data, a message the Fed has been sending for some time.  Markets reacted sharply, with stocks and commodities spiking, while bond yields and the dollar fell on the news that policy would remain easy for longer.  Good for U.S. financial conditions, but if you were looking for clarity, today probably didn’t provide it. A few thoughts. 1. If not now, when?  With the economy growing despite significant fiscal drag, most of us expected the Fed to start the process of tapering, along with additional guidance about policy aimed at avoiding a further rise in market interest rates.  Indeed, the “broad contours” of the economy are evolving as the Fed expected, but rather than beginning the taper, they concluded that more evidence was needed.  That may come in the next few months, but with the additional noise of the fiscal cliff and a Fed transition, the bar for starting a taper may be elevated into 2014. So the doves have prevailed, and have done so without additional dissents. 2. Goldilocks in 2016?  In the run-up to the meeting, markets were focused on Fed member’s forecasts for 2016, which were published for the first time today.  The “dots” on the Fed’s forecast chart show interest rates averaging 2 percent, but with a wide divergence (0.5 percent to 4 ¼ percent).  This compares to a market expectation of around 2¼ percent (in the longer run, interest rates are expected to stabilize at around 4 percent).  Growth and unemployment expectations for 2016 are also widely disbursed, and several participants expect unemployment to be near its long-run level at that point.  This suggests substantial differences of view on the path for policy.  2016 is a long way off, but it’s still an anchor for market interest rates. 3. Inflation still matters (being too low).  Bernanke in his press conference reminded us that inflation “persistently” below their 2 percent target is a reason to delay tapering (though that’s not their forecast).  It’s not just the labor market that determines the path for policy.  We knew that already, but if pounding the table on the risks from low inflation comforts markets, it’s worth it.  Relatedly, an inflation floor wasn’t introduced today, as some had speculated, but Bernanke signaled it could be considered in the future. 4. Triggers and thresholds, a clarification.  Markets arguably are still confused by the Fed’s communication strategy, and in particular how tightening is linked to the unemployment rate.  We have been told in the past that purchases were expected to end when unemployment was 7 percent (a forecast), and that rate hikes would be considered when it fell to 6.5 percent (a threshold for considering a move, not a trigger forcing one, although many market participants still don’t understand the difference).  Bernanke today addressed the confusion by emphasizing that the rate could go well below 6.5 percent before they tightened.   I am not sure he cleared it all up. 5. Structural and cyclical unemployment.  Bernanke highlights that most of the decline in unemployment this year reflects job growth rather than a decline in the participation rate.  (Since December, the unemployment rate has fallen from 7.8 percent to 7.3 percent, while the labor force participation rate has fallen from 63.6 percent to 63.2 percent.)  I have previously blogged on the debate over whether the decline in the participation rate is structural or cyclical.  I believe that, on balance, the evidence suggests that the majority of the decline is structural, reflecting longer-term trends and long-term unemployed workers losing connection to the labor force.  But some is cyclical, and as long as monetary policy can help at all, and inflation is low, it adds to the case for sustaining an easy policy. 6. Time consistent policy?  If the economy is near full employment by 2016, why should rates still be only 2 percent?  In recent weeks, a number of economists have criticized the credibility of the Fed’s forward guidance.  Any precommitment to keep rates low for long—as the Fed is doing and as economic theory suggests is needed—may require them to hold rates down even when conditions could justify an increase.  The idea is that the precommitment stimulates demand now, offsetting the possible costs of higher than targeted inflation down the road.  (By the way, the same would be true with nominal income targeting, a policy some Fed participants may support.) Is it appropriate to tie their hands in this way, and is the commitment even credible?  The question is all the more interesting given the transition at the Fed and the likelihood that the Federal Open Market Committee will look very different in a few years’ time.  Today we heard that the policy is the right one—and is time consistent—as long as activity evolves as expected.  Interest rates should remain low, in line with their central forecast, even as we approach full employment as the repair from the financial crisis continues. All in all, even though there was little change in policy, that in itself made this a significant meeting.  

The G20 communique and action plan, along with loads of background documents on the G20 economic program, have been released, though it may have been easy to miss amid the avalanche of Syria news.  The economic agenda was laid out in my colleague Stewart Patrick’s scene setter earlier this week, and leaders appear to have stuck to the script.  There was appropriately strong emphasis on growth and concern about high levels of unemployment.  There was encouragement for further financial reform.  In terms of substantive deliverables, the focus was on agreement to move forward with the June G8 plan to reduce tax avoidance and evasion, modest measures to boost investment, and an extension of the commitment to avoid protectionism.  All positive news, even if not substantial enough to distract markets from today’s U.S. job numbers. But the central economic theme at the summit, beyond Syria, was one of concern about the global recovery.  First the good news--leaders welcomed signs of recovery in the industrial world, and pledged to growth-oriented policies going forward.  Advanced G20 countries agreed to keep fiscal policy flexible and agreed monetary policy should be “carefully calibrated and clearly communicated”.  This all makes sense, but sidesteps the ongoing debate over austerity and central bank exit from easy money policies.  That said, it is nice to see that for the first time in years the G20 was not in crisis mode regarding the eurozone.  Hints of green shoots in Europe, however fragile, were welcomed. In contrast, the leaders recognized downside risks from sharp capital outflows and deteriorating growth prospects in the emerging world.  G20 emerging markets–notably India and Brazil–reportedly sought commitments from the Federal Reserve regarding tapering, but the Fed wasn’t at the meeting, and commentary at Jackson Hole last month already made clear that EM concerns are unlikely to have much of an influence on Fed policy. The action plan states that “facing increased financial volatility, emerging markets agree to take the necessary actions to support growth and maintain stability, including efforts to improve fundamentals, increase resilience to external shocks and strengthen financial systems." So, it’s up to them to fix their own problems. Beyond that, the action plan appears to list previous policy commitments and generally endorses urgent action.  My concern regarding emerging markets going forward is that, rather than strengthening macro policies and letting exchange rates adjust, these countries would turn increasingly to capital controls and macro-prudential measures contributing to protectionism and further deleveraging.  The communique restates leader’s commitment to open markets and resisting protectionism, and the commitment to improving global tax governance is an important step  toward improving the long-term incentives for capital flows.  However, it will be interesting to see if the above commitments hold in practice if market turmoil intensifies.