Will the Next Exit from Monetary Stimulus Really Be Different from the Last?

Suppose you run a manufacturing business—let's say, for example, widgets. Your customers are loyal and steady, but you are never completely certain when they are going to show up asking you to satisfy their widget desires.

Given this uncertainty, you consider two different strategies to meet the needs of your customers. One option is to produce a large quantity of widgets at once, store the product in your warehouse, and when a customer calls, pull the widgets out of inventory as required.

A second option is to simply wait until buyers arrive at your door and produce widgets on demand, which you can do instantaneously and in as large a quantity as you like.

Thinking only about whether you can meet customer demand when it presents itself, these two options are basically identical. In the first case you have a large inventory to support your sales. In the second case you have a large—in fact, infinitely large—"shadow" inventory that you can bring into existence in lockstep with demand.

I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:

I gather that a good measure of concern about the size of the Fed's (still growing) balance sheet comes from the notion that there is more inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).

I understand this concern, but I don't believe that it is entirely warranted. My argument is as follows: The policy strategy for tightening policy (or exiting stimulus) when the banking system is flush with reserves is equivalent to the strategy when the banking system has low (or even zero) reserves in the same way that the two strategies for meeting customer demand that I offered at the outset of this post are equivalent.

Here's why. Suppose, just for example, that bank reserves are literally zero and the Federal Open Market Committee (FOMC) has set a federal funds rate target of, say, 3 percent. Despite the fact that bank reserves are zero there is a real sense in which the potential size of the balance sheet—the shadow balance sheet, if you will—is very large.

The reason is that when the FOMC sets a target for the federal funds rate, it is sending very specific instructions to the folks from the Open Market Desk at the New York Fed, who run monetary policy operations on behalf of the FOMC. Those instructions are really pretty simple: If you have to inject more bank reserves (and hence expand the size of the Fed's balance sheet) to maintain the FOMC's funds rate target, do it.

To make sense of that statement, it is helpful to remember that the federal funds rate is an overnight interest rate that is determined by the supply and demand for bank reserves. Simplifying just a bit, the demand for reserves comes from the banking system, and the supply comes from the Fed. As in any supply and demand story, if demand goes up, so does the "price"—in this case, the federal funds rate.

In our hypothetical example, the Open Market Desk has been instructed not to let the federal funds rate deviate from 3 percent—at least not for very long. With such instructions, there is really only one thing to do in the case that demand from the banking system increases—create more reserves.

To put it in the terms of the business example I started out with, in setting a funds rate target the FOMC is giving the Open Market Desk the following marching orders: If customers show up, step up the production and meet the demand. The Fed's balance sheet in this case will automatically expand to meet bank reserve demand, just as the businessperson's inventory would expand to support the demand for widgets. As with the businessperson in my example, there is little difference between holding a large tangible inventory and standing ready to supply on demand from a shadow inventory.

Though the analogy is not completely perfect—in the case of the Fed's balance sheet, for example it is the banks and not the business (i.e., the Fed) that hold the inventory—I think the story provides an intuitive way to process the following comments (courtesy of Bloomberg) from Fed Chairman Ben Bernanke, from last week's congressional testimony:

"Raising interest rate on reserves" when the balance sheet is large is the functional equivalent to raising the federal funds rate when the actual balance sheet is not so large, but the potential or shadow balance sheet is. In both cases, the strategy is to induce banks to resist deploying available reserves to expand deposit liabilities and credit. The only difference is that, in the former case, the available reserves are explicit, and in the latter case they are implicit.

The Monetary Policy Report that accompanied the Chairman's testimony contained a fairly thorough summary of costs that might be associated with continued monetary stimulus. Some of these in fact pertain to the size of the Fed's balance sheet. But, as the Chairman notes in the video clip above, when it comes to the mechanics of exiting from policy stimulus, the real challenge is the familiar one of knowing when it is time to alter course.

By Dave Altig, executive vice president and research director of the Atlanta Fed

 

In the interest of precision

As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:

"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…

"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."

The minutes are pretty clear about what this information is intended to convey…

"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."

…and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:

"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."

That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

By Dave Altig, senior vice president and research director at the Atlanta Fed

 

Do-It-Yourself Funds Rate Probabilities

If you are reading this, chances are you are familiar with these pictures depicting what the future (or the Federal Open Market Committee) might bring for the federal funds rate, as estimated from options of fed funds futures:

   

   

These used to be a regular feature here at macroblog, and have for some time been available daily at the Federal Reserve Bank of Cleveland's website.  They still are, but now the Cleveland site also has a new feature that allows you to customize the estimates, selecting how many alternative rate options you want to consider, whether to include a term premium, and if so how big you want that premium to be.  Knock yourself out. 

And So It Begins?

From the Financial Times:

Last week was significant in that the dollar breached an important barrier, according to traders. Since May, it had been relatively stable within a euro trading range of $1.25-$1.30. Its fall outside this range left investors wondering whether that was simply due to a lack of liquidity around the Thanksgiving holiday or the start of a more sustained slide in the US currency...

An even bigger concern is growing talk of global central banks diversifying their foreign exchange reserves away from the US currency. One factor supporting the dollar has been huge purchases by foreign central banks. Since 2001, global currency reserves have soared from $2,000bn to $4,700bn according to the IMF, with two-thirds of the world's stockpiles held by six countries: China, Japan, Taiwan, South Korea, Russia and Singapore.

Anxieties over reserve diversification have been around for at least six months, with central banks in Russia, Switzerland, Italy and the United Arab Emirates announcing plans to cut the proportion of dollars held in their reserves. A shift by central banks away from dollars would remove a key source of financing for the US deficit...

Fan Gang, director of China's National Economic Research Institute and a member of China's monetary policy committee, saw things differently. He said the real problem the world faced was an overvalued dollar, not only against the renminbi but against all the leading currencies.

His comments come at a time when speculation is increasing that China, which is thought to hold 70 per cent of its foreign currency stockpile in dollars, is considering a fundamental change in its reserve allocation. These concerns were highlighted on Friday when Wu Xiaoling, deputy governor of the People's Bank of China, said Asian foreign exchange reserves were at risk from the dollar's fall.

And there is this (hyperlink added):

... Market expectations, monitored by the Federal Reserve Bank of Cleveland, show that investors think there is a 30 per cent chance of a cut in US rates in March.

Just as it seems interest rates in the US may have peaked, they are being increased by the European Central Bank, the Bank of England and the Bank of Japan. The ECB is expected to raise its main rate from 3.25 per cent to 3.5 per cent at its December 7 meeting. The big question is whether Jean-Claude Trichet, ECB president, will signal further increases in 2007.

Here's something to think about.  If the move away from the dollar is for real -- with the presumably inevitable result that current account deficits will not continue to support domestic spending in the United States -- the result will almost certainly be higher U.S. interest rates.  Here's a position, which I endorse, about what that might mean for monetary policy:

We believe that changes in the federal funds rate should be considered on the basis of where economic forces are taking market interest rates, a perspective stemming from several presumptions about the way our economy works. First, “a balance between the quantity of money demanded and the amount the central bank supplies” requires the federal funds rate to adjust roughly in alignment with changes in real—that is, inflation-adjusted—returns to capital.

In other words, if long-term real interest rates rise, monetary policy becomes more expansionary even if the federal funds rate doesn't change.  (This is roughly behind the idea of associating "easy" monetary policy with a steep yield curve, and "tight" policy with a flat yield curve.) That is worth keeping in mind as you read stories like this one:

In another volatile day on the currency markets, the dollar recovered some poise against the euro on Wednesday after an unexpectedly large upward revision to US growth 2.2 per cent in third quarter against an estimated 1.6 per cent and consensus forecasts of a 1.8 per cent rise...

Speaking in New York overnight, Mr Bernanke struck a hawkish tone on US interest rates, saying that inflation in the US remained “uncomfortably high”.

Analysts said that, while it might be something of a surprise that the dollar had failed to derive support from Mr Bernanke’s remarks, he might be in danger of “crying wolf” over US inflationary pressures.

You know, sometimes the wolf is really there.

All Systems Stop

At midweek, Tim Duy wrote this at Economist's View:

Futures markets appear to have no clear conviction on the outcome of the next FOMC meeting. The message is that market participants are looking for one more rate hike, either in August or September. Moreover, they doubt the Fed’s position that “pause does not mean done.”

That was indeed the case then, but this is now.  Bringing you tomorrow's news today, here is what the probabilities estimated from options on federal funds futures look like as the week of before the next meeting of the Federal Open Market Committee begins:

   

   

   

Friday's second quarter GDP report really wasn't all that bad, but apparently not as good as expected was enough.  And Professor Duy was right -- the market does seem to doubt the Fed’s position that “pause does not mean done.”

   

   

It's still a relatively long time to September, but at this point it is hard to see what might significantly shift sentiment about this week's meeting.

UPDATE:  I take it back. Tomorrow's ISM and PCE reports could loom large.  And there was this, from Federal Reserve Bank of St. Louis president William Poole:

Federal Reserve Bank of St. Louis President William Poole said he's undecided on whether the central bank should raise interest rates at its next meeting in eight days.

Poole, speaking to reporters after a speech in Louisville, Kentucky, said he's "50-50'' on the decision, which needs "all our analytical skills.'' Recent data show slowing economic growth, while inflation has "tilted'' upward, he said. Containing inflation is the Fed's "primary'' goal, he added.

UPDATE II: Action Economics (subscription required) reports:

SF Fed's Yellen did note rule out more rate hikes though she said that the Fed funds rate is "in the vicinity" of the right level, noting the Fed remains responsive to the data and she expects below-trend growth later in 2006 to pull down inflation. Yellen also confirmed that the Fed was mindful of policy lags and even though core inflation is above her comfort zone, the Fed can pause before it begins to decline, while retaining a more restrictive policy setting... Overall the comments are fairly balanced and do not rule in or out another hike in August

Data Independence

This really is not much of a surprise, but I think this pattern of intraday probabilities estimated from fed-funds futures options is interesting:

   

   

There are plenty more more pictures in this spirit at Econbrowser. 

Post-FOMC Market Update

The pudding, from the Financial Times..

“Traders probably sense from the statement that the Fed is proceeding cautiously, even reluctantly, in terms of future tightening,” said Alan Ruskin, strategist at RBS Greenwich Capital. “It seems like it may have caught the market off guard.”

Futures traders priced in a reduced probability of an August rate rise – still about 65 per cent cent, but down from about 90 per cent the day before.

... along with some more proof in pictures:

   

   

That change is not quite as dramatic as the numbers quoted from the Financial Times -- a result of using options rather than futures alone in the calculations of the probabilities -- but the story remains more or less the same. The details and data will be available later this morning on the Cleveland Fed website, where you will also find the first hint of what the market thinks September will bring:

   

UPDATE: Meanwhile, in the global blogger village: The Capital Spectator observes that the decision was "a surprise to no one", but the statement was "anything but routine."  (CS also digs up an analyst willing to muse "If we get a bad consumer price index report, for instance, the Fed might do something the next day".) The Nattering Naybob reads the statement as "status quo" (and puts the decision in the broader context of the day's news, as does The Skeptical Speculator.) But The Prudent Investor is not buying the dove interpretation.  William Polley thinks "another one or two quarter point steps are probably in the cards." Hypothetical Bias reminds us that "the Fed has a history of overdoing tightening regimes" and suggests that to "demonstrate his inflation-fighting credentials, Bernanke may continue this pattern." A full parsing of the Committe' statement is available at Economist's View and at The Mess That Greenspan Made.

The New Economist has some links that I missed.

Sort of related: Contango has an interesting panel of Morgan Stanley economists discussing whether monetary policy has defnitely turned restrictive. (Answer: Yes.)  Greg Mankiw relays (with some skepticism) an attempt to resurrect the reputation of Arthur Burns.

UPDATE II: Michael Shedlock has many thoughts, all of which lead to the conclusion that "the recession of 2007 is looming ever larger."

No More Questions About The June FOMC Meeting

The aftermath of the inflation report on market expectations about what the FOMC will do next:

 

 

For the first time in our estimates, the probability that the funds rate target will be pushed to 5.5% by the time the August FOMC meeting is done exceeds the implied probability of a pause sometime this summer (if only by a little):

 

 

The details and the data will be available later this morning at the Federal Reserve Bank of Clevelandf website.

UPDATE: Calculated Risk agrees: "The June Fed Debate Appears Over".

Hawk Amphetamines

From Greg Ip, in the Wall Street Journal (page A6 of the print edition):

Inflation alarms at the Federal Reserve rang louder yesterday as a top official said slowing economic growth may not be enough to contain inflation if the public's inflationary psychology intensifies.

"If inflation turns out to exceed ... our target range, I do not believe we can count on a slowing economy to bring inflation down, by itself, quickly," William Poole, president of the Federal Reserve Bank of St. Louis, said in an interview. If inflation expectations rose in "a persistent way...we could expect to see that show up in measured inflation in fairly short order.

And another familiar story:

   

   

I guess you know by now that you can find the data from these pictures -- and how they are constructed -- later today, at the Cleveland Fed web site.

The Hawk Becomes The Pheonix

The New York Times sums up the interpretation of yesterday's remarks by Chairman Bernanke at the International Monetary Conference in Washington D.C.: 

Ben S. Bernanke, chairman of the Federal Reserve, warned Monday that recent inflation trends were "unwelcome developments," indicating that he was far less worried about signs of weaker economic growth than about the danger of higher prices.

I added the emphasis there, as I did read the speech, and confess I couldn't quite find where he said he was "far less" worried about economic growth.  To be fair, an impartial observer might infer that this does represent the Federal Open Market Committee's general orientation, based on the change from this language in the press statement following the March meeting...   

The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.

... to this language in the statement following the May meeting:

The Committee judges that some further policy firming may yet be needed to address inflation risks...

Of course, everyone knew this last week when the May employment numbers sent expectations of another rate hike in June into a skid. Apparently, on Friday those numbers made operative this clause in the May statement...

The Committee... emphasizes that the extent and timing of any such firming will depend importantly on the evolution of the economic outlook as implied by incoming information.

... and just as apparently market participants believe the invoking of that clause was revoked by the Chairman in his comments on Monday.  Again from the New York Times:

In his toughest comments yet about the risks of inflation, Mr. Bernanke said consumer prices were rising faster than he would like. He gave short shrift to evidence of a slowdown in hiring, and he conspicuously avoided repeating his earlier suggestion that the Fed might consider a "pause" in its two-year program of steady interest rate increases.

The story, from prices on options for fed funds futures:

   

   

I know I said I would stop posting these things unless something interesting happens, but, by golly, interesting things just keep happening.

The data from the above picture, as is always the case now, are available from the Cleveland Fed.