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Perspectives on "Non-Traditional" Monetary Policy

Bill Hester, CFA
October 2010
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Reprint Policy

Sometimes a performance is unable to live up to its billing. That was the case for the speech given by Fed Chairman Ben Bernanke in Boston on Friday. In fairness, he had little chance of topping the expectations that investors have heaped upon him during the past few weeks. In the speech – titled “Monetary Policy Objectives and Tools in a Low-Inflation Environment” – he suggested that the Fed would likely re-instate quantitative easing, but didn't give dates and didn't give amounts.

Those details may come in two weeks when the Fed convenes to discuss its next move. Even though the speech lacked specifics, it did develop and define further what Bernanke believes to be the Fed's benchmark for success in meeting its dual mandate of targeting full employment and the “mandate-consistent inflation rate”. It also laid out some of the risks of non-conventional forms of monetary easing.

Chairman Bernanke's speech was the bookend to a speech given earlier this month by Bill Dudley, the President of the New York Fed. The two speeches made similar arguments: that the Fed's mandate was not being met because inflation was too low and unemployment was too high. The non-conventional measures of monetary policy they discussed fell broadly under three policy areas: communicating the expected path of policy rates based on inflation targets, targeting price levels, and expanding the Fed's balance sheet (quantitative easing).

Communicating Interest Rate and Inflation Objectives

Both FOMC members stressed the importance of communicating the Fed's inflation objectives to investors. Bernanke suggested that, “Central Bank communication provides additional means of increasing the degree of policy accommodation when short-term nominal interest rates are near zero. A step the Committee could consider, if conditions called for it, would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than the market expects.”

Bernanke did express some hesitation about this approach. “A potential drawback of using the FOMC's statement in this way is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee's policy intentions with sufficient precision and conditionality.”

Not being able to offer precision and conditionality for communicating the path of future short-term interest rate may indeed be a problem. The larger issue though, it seems, is that this approach attempts to solve a problem that isn't immediately apparent. The graph below plots the fed funds rate, along with the market's forecast for the direction of rates over the next two years.

Investors don't expect short-term rates to rise materially for a long time. Based on futures contract prices, investors expect the fed funds rate to increase by about a quarter of a percentage point in the middle of 2012. Eurodollar contracts suggest that investors don't expect the Fed to normalize the fed funds rate at 2 percent until 2015. Treasury note yields are under 1 percent for maturities of less than five years. Low rates at the short end of the curve are probably partly explained by the lessons that Japan has offered to investors. Certainly, bond investors are considering that there is some risk of the US falling into a persistent liquidity trap. So it's difficult to imagine to what extent investors would alter their expectations for policy rates based on slightly different wording contained in FOMC policy statements, which already include the suggestion that rates will stay exceptionally low for an extended period of time.

Targeting Price Levels

NY Fed President Dudley also argued for the clear communication of inflation objectives, and advocated a goal for the Fed to effectively manage inflation expectations. When the Fed's interest rate policy is stuck at its zero bound, he argued that “a decline in inflation expectations drives up real interest rates and thereby increases the real cost of credit which cannot be offset by simply lowering the fed funds rate. Thus, in a very direct sense, a fall in inflation expectations when the target interest rate is at the zero bound represents a de facto tightening of monetary policy and of financial conditions.”

In his speech, Dudley floated the idea of targeting price levels instead of inflation rates. This would allow the Fed to let inflation run at higher levels than they would typically be comfortable with to “catch up” from earlier periods of disinflation and deflation. “For example, if inflation in 2011 were a .5 percentage point below the Fed's inflation objective, the Fed might aim to offset this miss by an additional .5 percentage point rise in the price level in future years.”

While there aren't many historical examples available to study the effectiveness of targeting price levels, Japan does offer a modern-day template. In 1999, the Bank of Japan formalized its Zero Interest Rate Policy (ZIRP). In addition to setting its policy rate at essentially zero, it also told investors that it would maintain a commitment to that rate “until deflationary concerns were dispelled”. In the summer of 2000, with some optimism that the economy was recovering the Central Bank raised rates by 25 basis points. It returned to a zero interest rate policy in March of 2001, as its economy faltered and world stocks markets entered into a bear market.

In addition to the zero interest rate policy, this time the Japanese Central Bank also told investors that they would leave rates low until they believed CPI inflation would stay above zero for a sufficient amount of time. Unfortunately, even with this newly worded pronouncement, price levels continued to decline.

That's one risk of relying on this strategy. The chart below shows Japan's core inflation rate since 1990. While setting a price level target might be effective in an economy that produces offsetting periods of deflation and then inflation, in Japan's case persistent deflation never gave the BOJ this opportunity. Implementing Dudley's idea of targeting price levels requires the Central Bank to be presented with the opportunity to let inflation run above its target level. Japan's economy has showed that this type of opportunity doesn't always present itself.

Bernanke and Dudley both discussed the potential risks of further expanding the Fed's balance sheet. They each focused on the risk that inflation expectations could come unhinged. “There could be significant costs. For example, if people mistakenly concluded that the Fed was tinkering with its long-run inflation objective, this could lead to greater uncertainty about future inflation. This might lead to higher risk premia and higher nominal interest rates that would undermine the effectiveness of such a policy to stimulate the economy,” Dudley said.

Quantitative Easing

If keeping long-term inflation expectations in check is how the Fed suggests people should track the risks involved in quantitative easing, the early results are not inspiring. Ten -year inflation expectations are up 60 basis points since the beginning of September, and were up almost 20 basis points just last week as the probability for QE turned toward the direction of certainty. The slope of the yield curve is also changing noticeably. The graph below shows the spread between the two-year note and the three-month bill (in blue) and the spread between the 30-year bond and the 10-year note (in red).

Firm long-term yields aren't necessarily bad. They might reflect investor expectations that QE will be effective in stimulating economic growth. But TIPS prices suggest that most of the increase in yield spreads of late has come from investors pricing in higher inflation expectations. And expectations of higher rates of inflation are being priced more aggressively into longer-term nominal bonds. The Fed would prefer to see medium-term inflation expectations rise, while long-term inflation expectations stayed low. This would suggest that investors have confidence that the Central Bank is able to orchestrate some near-term inflation, which the Fed hopes might motivate consumers and businesses to ramp up their spending, while holding long-term inflation expectations in check. The graph shows that the exact opposite set of expectations are being priced into the bond market. Investors expect further disinflation over the short-to-medium term, while their long-term inflation expectations are rising. The early bond-market consensus on the risks of pursuing QE – unhinged long-term inflation expectations - is not favorable.

Selling the QE News

Stock investors may want to show caution here. In Japan, the period surrounding the announcement of quantitative easing was more favorable for equities than the period that contained the actual bond purchases. Beginning in March of 2001, the Nikkei quickly rebounded from a 15% correction on the announcement that the Bank of Japan would buy Japanese government bonds. That optimism faded just as rapidly. Six weeks later the market peaked and would fall by more than 30 percent in just four months as investors realized that bond purchases were neither boosting private demand nor the level of inflation expectations. Eventually the Nikkei bottomed in April of 2003, more than 45 percent below the peak in prices immediately following the QE announcement.

If we use Japan as a template, it's difficult to be optimistic about quantitative easing providing meaningful stimulus to the economy. Quantitative easing had little effect on boosting private demand, and deflation had persisted during the expansion of the Bank of Japan's balance sheet. Stock investors in particular should be cautious. After a short celebration around the time QE was announced in Japan, the Nikkei turned down meaningfully during the actual bond-buying period. The expectation for quantitative easing in Japan was more exciting to investors than its implementation.


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