How do you convince people that doing less isn't really doing less?
That's the question Ben Bernanke has been trying to answer the past six months, and it looks like he's finally found one. That's reducing the Fed's bond-buying, but offsetting that by saying it will keep rates low for even longer.
It's less purchases and more promises. More specifically, the Fed will "taper" its bond purchases from $85 to $75 billion a month. And it will keep doing so in $10 billion increments next year as long as the recovery stays on track. But it will try to inject just as much monetary stimulus as it's taking out by strengthening its promises. Indeed, the Fed now says it will likely keep rates at zero "well past" the time unemployment falls below 6.5 percent, especially if inflation stays below its 2 percent target as expected.
Markets approved. Stocks jumped, bonds didn't fall, and expectations of future rates barely budged. In other words, Bernanke finally convinced markets that tapering isn't tightening, even though he said it was a few months ago. Neat trick.
Okay, some background. Back in September 2012, the Fed began buying $85 billion of Treasury and mortgage bonds a month—so-called QE3—and said it would keep doing so until there was "substantial improvement" in the labor market. But just how substantial is "substantial"? Good question. The Fed didn't really say. What it did say was how long it would keep interest rates near zero. This forward guidance, which it fine-tuned in December 2012, said it would not raise rates before unemployment fell below 6.5 percent or inflation rose above 2.5 percent.
Notice the timing here. The Fed eased policy twice right before the fiscal cliff—remember that?—was set to hit. In other words, Bernanke was trying to keep us out of the recession that Congress was trying to create with all of its austerity. And he succeeded. Despite all the spending cuts and tax hikes, the economy grew about as much in 2013 as it did in 2012 and 2011. Not only that, but unemployment fell further than expected. Now, part of that was people giving up hope of finding work, rather than actually finding work. But it was still enough to make markets wonder if this was the substantial improvement the Fed was looking for.
To Taper or Not to Taper
It was. And then it wasn't. And it wasn't, because the Fed had said it was. Got that? Let's explain.
Back in May, Bernanke thought things were good enough that the Fed could soon start drawing down its bond-buying. Markets freaked out. And they freaked out even more a month later when Bernanke said he expected the draw-down to start by the end of the year, and finish by mid-2014.
Now, not all market freak-outs are created equal. From the Fed's perspective, it's not a problem if, say, emerging markets that had seen QE3 dollars pour in started to see them pour out—and their currencies collapse. But it was a problem when markets thought an earlier taper meant earlier rate hikes. That wasn't what the Fed wanted them to think. The Fed wanted them to think that bond-buying and interest rate decisions were completely separate things. But, as Paul Krugman pointed out, they thought a Fed that was more hawkish than expected on QE3 would be more hawkish than expected on forward guidance too. That is, purchases made the Fed's promises more credible. So this taper talk made long-term interest rates shoot up. And long-term interest rates shooting up hurt the recovery—enough that it was part of the reason the Fed didn't taper as expected in September.
Since then, the Fed has tried to explain that less bond-buying doesn't mean rates will rise faster. The opposite, actually. The Fed will try to counteract its reduced bond-buying by raising rates even slower than it planned before. So it's taking monetary stimulus out with the right hand, and putting it back with the left. And there's still plenty more it can put back. After all, the Fed hasn't explicitly lowered its unemployment threshold, nor added an inflation floor. It's just suggested it will do both—and that was enough for now. That the taper didn't make stocks fall or expected rates rise shows that it was.
But there's still work to do. Unemployment is still above target, and inflation is still below. In fact, the Fed expects inflation to stay below target all the way through 2016. As Robin Harding of the Financial Times points out, that's the Fed admitting that it plans to fall short of what it says the best policy is right now. That best policy—what Janet Yellen calls "optimal control"—calls for above-target inflation the next few years to bring down unemployment faster. You can see what that looks like in the chart below from a speech she gave last year.
In other words, the Fed doesn't need to figure out how to keep monetary stimulus constant even as it tapers. It needs to figure out how to increase monetary stimulus even as it tapers. Or stop tapering.
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