Fed Wrestles market

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Following last week’s tapering debacle, the fed has been putting out all the feelers on tapering.

I expected to hear less about tapering and more about ‘active balance sheet management’ from here on – however Hilsenrath’s new Fed note makes me think the Fed is very determined to get their point across. The message is that the Fed will soon slow the pace of easing (remember it is the stock that the Fed thinks does the work, so every purchase is another rate cut).

The WSJ’s incomparable Jon Hilsenrath has just published on how the Fed is wrestling with market expectations about the pace of QE. Wrestling is the right metaphor – for the main channel through which this stuff works is expectations, and if the Fed does less than the market expects, that is a tightening.

My own guess is that bond yield will rise before the taper, and decline once it happens. Just like in ‘normal’ rate cycles, and the opposite of what occurs around the balance sheet expansion (yields decline into the balance sheet expansion, and then rise when the Fed delivers the hoped for bond purchases / stimulus).

Anyhow, over to Jon (my emphasis):

Fed officials have been struggling of late managing expectations about its plans for the $85-billion-a-month bond-buying program, known as “quantitative easing.”

At their policy meeting in May, Federal Reserve officials expressed anxiety about shifting market expectations for the Fed’s $85 billion-per-month bond buying program. “A few members expressed concerns that investor expectations of the cumulative size of the asset purchase program appeared to have increased somewhat since it was launched last September despite a notable decline in the unemployment rate and other improvements in the labor market since then,” according to the minutes of the meeting released last week.

One bit of evidence before the Fed at its last meeting was a survey, conducted by the Federal Reserve Bank of New York before each meeting, that asks big banks that serve as its main counter parties in the bond market a wide range of questions about their expectations for Fed policy. The survey, released to the pubic last week, warrants attention.

The latest survey showed that as of late April, most market participants expected the Fed to still be purchasing $85 billion per month of bonds by the fourth quarter. Most didn’t expect the program to end until the second quarter of 2014. (See question #5) In similar surveys in January and March, market participants expected the Fed to begin winding down the program by the fourth quarter and to have completed it by the first quarter of 2014.

Our own survey of private sector economists shows a similar shift in expectations.

Low inflation and a soft jobs report for March appear to have helped to cause this shift in expectations. But the market might have gotten ahead of itself. Many Fed officials expect growth and employment to pick up later in the year, and many don’t expect the inflation slowdown to last.

But if Fed officials were worried that the market was beginning to expect too much by early May, they chose an odd way of managing those expectations. In their post-meeting statement they inserted a line noting that they were prepared to either increase or reduce their bond purchases, depending on how the economy evolved. The statement was meant to emphasize their willingness to be flexible about the program, but many market participants took it as confirmation that the Fed was starting to lean toward doing more.

Last week marked a potential course correction in the expectations game. Fed chairman Ben Bernanke’s reset market expectations when he told the Joint Economic Committee that the Fed might start winding down the program within the next fed policy meetings. The Fed’s hawkish meeting minutes amplified the point.

The challenge is especially hard now, because the Fed doesn’t have handy tools to measure market expectations. Before the financial crisis, the Fed’s main tool was a short-term interest rates – the one at which banks lend to each other overnight, the federal fund rates. It could look to the futures market to gauge what markets expected the Fed to do and when. But futures markets don’t track expectations for bond buying, leaving the Fed in a guessing game.

That’s why surveys like the New York Fed primary dealer survey are now so important.


    1. More seriously, Sumner frustrates me, but he has made me better at my job by focusing me more keenly on expectations.

  1. His criticism was dross. It was almost like he hadn’t read Kruggers at all. That is why the comments were so hard hitting

    I did say it was very unusual for Hamilton though.

    Indeed I expect ( and hope) it to be a one-off

  2. Aren’t there two separate things for the Fed : first, working out how much demand the market is expecting and how much that changes as policy changes – NGDP futures might help the Fed work this out. The second thing is deciding how to signal its policy intentions. NGDP futures won’t help the Fed in advance of its statements because the Fed won’t know how much it needs to taper until it has said something and gauged market reaction. Which raises the question – why does the Fed bother talking about how and when it may change its purchase schedule? They should just say that their policy is focused on meeting their objective and will continue to do so. This is not to say an NGDP futures market is not worthwhile – it is – but it is not required to enable the Fed to determine what it should say. When rates are positive, the Fed doesn’t say they intend to increase or decrease the FFR at some point in the future per se – they just talk about demand and inflation. So why talk about the mechanics of policy now instead of the objectives of policy? What am I missing?

    1. The commitment to bond buying is a signal about the period of time for which the fed expects to be at zero. In woodford et al, it is a signal (and probably practical) commitment to be easier than old old rule.

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