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September 6, 2013 7:33 pm
The US Federal Reserve is searching for ways to strengthen its forward guidance in order to keep interest rates low whether or not it chooses to taper asset purchases from $85bn a month in September.
The sluggish August jobs report is likely to pull the Fed in two directions. On one hand, it raises doubts about the momentum of jobs growth, which argues for caution – especially given the large rise in market interest rates recently.
On the other hand, the fall in the jobless rate to 7.3 per cent implies less growth is needed to get back to full employment, perhaps because of structural damage to the economy. That is an argument for tapering. Other data such as business surveys have come in strong and inflation has stabilised in the past couple of months.
With the Fed’s broad tapering strategy already set, the result is likely to be an open debate on the rate-setting Federal Open Market Committee about whether September is the right month, and how fast to go. A spike in uncertainty about Syria or fiscal policy, for example, could be a reason to delay.
Given a strong desire among Fed officials to make sure markets do not misinterpret tapering, however, a likely option is a small reduction in asset purchases combined with a new effort to strengthen the Fed’s interest rate guidance.
“For me, to start the wind-down, it will be best to have confidence that the incoming data show that economic growth gained traction during the third quarter of this year and that the transitory factors that we think have held down inflation really do turn out to be transitory,” said Charles Evans, president of the Chicago Fed, in a speech on Friday.
Mr Evans, a voting member of the FOMC this year, is regarded as a monetary policy dove. He said the Fed should buy at least $1.25tn in assets between January 2013 and the end of its third round of quantitative easing. That is more consistent with a first tapering of asset purchases in December.
But Kansas City Fed president Esther George said it would make sense to taper purchases from $85bn to $70bn in September and split buying evenly between Treasury and mortgage-backed securities. It currently buys $45bn of Treasuries and $40bn of MBS each month.
One forward guidance option is for the Fed to state that it will not raise interest rates if it expects inflation below its long-run goal of 2 per cent. That is already implied by the Fed’s objectives, but stating it could help to control market expectations by directly linking its inflation forecasts to an eventual interest rate rise.
The Fed is also considering how to signal that when interest rates do eventually rise they are likely to go up slowly. A way it could do that is by drawing attention to its 2016 economic forecasts – which will become available this month – perhaps during Mr Bernanke’s press conference.
Those forecasts may show the economy running close to full employment by the end of 2016, but a large proportion of the FOMC still favouring interest rates of just 1 or 2 per cent. It would reflect an expectation that, even as late as 2016, there will be damage from the financial crisis that requires a low real interest rate. Some Fed economists believe that rates may not get back to their long-run equilibrium of around 4 per cent until as late as 2018 or 2019.
Even though the membership of the FOMC is about to change – including the chairman and several governors – the forward guidance could still be credible if it reflects an economic analysis likely to be shared by the new personnel.
A desire to reinforce forward guidance could extend to the design of any taper. Markets may interpret the initial move to taper as a signal about the aggression of subsequent changes, and combined with uncertainty about the growth outlook, that will be an argument for making the first reduction in purchases small.
There is some support for tapering Treasuries rather than MBS, but also caution about trying to fine-tune policy too much, especially if the initial taper is small.
Data such as business surveys have come in strong, however, and inflation has stabilised in the past couple of months.
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