Loss of Certainty at the Fed

To taper or not to taper: that is the question that has defined the Federal Reserve, market participants, and the public debates over monetary policy throughout the last twelve months. Following the start of the third round of Quantitative Easing on September 13, 2012, the Fed is currently represented by the uncertainty around the tapering of QE3.

Over the past two decades, the Federal Reserve has made an effort to increase the transparency of its monetary policy. Since 1994, the Fed has announced its target for the federal funds rate, published Federal Open Market Committee statements, released FOMC minutes three weeks after meetings, and, in 2012, even attached explicit threshold indicators that would alter the Fed’s view of longer run monetary policy goals . This idea of “forward guidance” serves as a way for the central bank to communicate with households, businesses, and market participants about the FOMC’s stance on monetary policy and its future actions. Through forward guidance, the Committee expects that more certainty in the Fed’s monetary policy can push down long- term interest rates, increase capital investment, and improve financial conditions.

Even the Federal Reserve Bank of San Francisco’s research has indicated that the effectiveness of QE2 was largely caused due to the forward guidance of the central bank, where the Fed’s macroeconomic model “suggest(s) that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.”

While the Fed has acknowledged the benefits of forward guidance, the Federal Open Market Committee is trying to determine how and when to begin tapering its asset purchases. Following the September FOMC meeting, the FOMC press release statement indicated that the “the Committee decided to await more evidence that progress will be sustained before adjusting the pace of its purchases. Accordingly, the Committee decided to continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month and longer-term Treasury securities at a pace of $45 billion per month.” However, despite the fact that the Fed has forward guidance for the federal funds rate, the tapering of QE3 remains up in the air. There was much anticipation that tapering would begin in September, but in a 9-1 vote, the FOMC voted to keep long scale asset purchases at $85 billion per month.

The recent government shutdown has made it harder to forecast and understand the economy. The dismissal of 800,000 “non-essential” government workers includes employees of the Census Bureau, Department of Commerce, and the Department of Labor who attain and analyze economic indicators. Without these economic indicators, there has been more uncertainty in the economy, and it may be more difficult for the Fed to understand current economic conditions. Economists predict that the 16-day government shutdown will shave 0.3% off the 4th quarter of GDP growth in 2013. The government shutdown has also created a gap in the data stream of indicators the Fed needs in order to understand current economic conditions. Due to this hole in the data stream of economic information, the FOMC will be unable to fully assess the economy during its December meeting.

A taper in January is also questionable. Following the January meeting, Bernanke will step down and four new Federal Reserve Bank presidents will fill rotating seats in the committee. It seems plausible that tapering will most likely happen in March, but waiting till then would add another $255 billion to the Fed’s swelling $3.81 trillion balance sheet.

Because the Fed defines “solid economic growth,” the Fed’s tapering is not bound to any concrete threshold. In a June speech, Bernanke predicted that asset purchases would come to an end when the unemployment rate was in the “vicinity” of 7%. Despite a 7.2% unemployment rate, Bernanke has still asserted that a reduction in asset purchases would not begin until there is “solid economic growth supporting further job gains.” Although unemployment has been dropping steadily since April 2010, a lower unemployment rate does not always indicate more jobs. As economist Paul Krugman points out, the declining unemployment rate is mostly due to the paralleled decreasing percentage of Americans participating in the labor force.

As The Economist understands, “The Fed needs to spell out its priorities and plans much more fully.” In our current uncertain and tepid economic recovery, the Fed must consider the positive attributes of more transparency. John Williams, president of the San Francisco Fed, recognizes that “every step we’ve taken toward greater openness and clearer communication has made our policies more effective and has served to enhance the Fed’s accountability and transparency.” It is time for the FOMC to give the market a better understanding of the impending unwinding of the Fed’s balance sheet.