BackInTheBlackBlog is on vacation this week, but let me offer just some brief reactions to two pieces of news of last week.
You may have seen repeated stories about Federal Reserve Governors and regional bank presidents doing the rounds to speak about monetary policy. I attended a speech by Jerome Powell, one of the most recently appointed Governors. I worked with Jay on his efforts to explain the dangers of playing a game of chicken over the statutory debt limit, and can testify that he is knowledgeable, skilled and impartial. He will be an excellent Governor for these trying times. But his remarks this week illustrate just how difficult the Fed’s job will be.
The speaking rush by the Fed comes because of what Jay described as an out-of-scale market reaction to Chairman Bernanke’s press conference after the most recent Federal Open Market Committee (FOMC) meeting. At that meeting, the members downgraded their individual near-term economic forecasts, but upgraded their forecasts for a few quarters down the road – citing evidence that the economic recovery has grown firmer roots. On the basis of those stronger expectations, Chairman Bernanke spoke in his press conference of his anticipation that the Fed would begin to taper off its current monthly purchases of longer-term securities in the open market as of September of this year, and would reach zero purchases by the middle of next year.
Reacting to this discussion, the financial markets went bonkers, with large one-week increases in long-term Treasury and mortgage interest rates. This raised the prospect of an adverse near-instantaneous feedback loop from housing-is-recovering to OMG-the-Fed-is-going-to-tighten to sell-bonds to higher-mortgage-rates to housing-plunges. It was a fear of such a market reaction that sent Fed Governors and Bank Presidents rushing to the microphones and television cameras.
Jay’s message – beyond characterizing the market reaction as out-of-scale to Chairman Bernanke’s signal – was to emphasize the magic words, “data-driven.” Jay made clear that Chairman Bernanke intended to describe a scenario that would play out if the central tendency of the Governors’ forecasts materialized; if the economy turned out softer, the Fed would delay its tapering off of the asset purchases.
That is of course the right policy process. But here is the rub: We are in a truly unprecedented situation; and there is a very fine line between being “data-driven” and “driving in the rear-view mirror.” Chairman Bernanke and the FOMC decided to send their initial signal on the basis of a forecast. Because the data lag actual events, even the FOMC’s final decision necessarily will be made substantially on the basis of a forecast of the future – else it could be too late. And because the situation is unprecedented – with the Fed sending pressure through previously unexplored channels to stimulate economic activity – the reactions of the market to further unprecedented steps, like withdrawing quantitative easing, are unpredictable and could easily be just as excessive as were the reactions to Chairman Bernanke’s press conference. So to avoid acting too late, and therefore quite possibly causing or exaggerating bubbles in the economy or setting off an accelerating inflation, the FOMC will have to act on a forecast – just as they spoke on a forecast through Chairman Bernanke after their recent meeting.
The FOMC clearly has thought this unprecedented situation through about as well as can be done. But there should be no doubt that they face a daunting task. Their decisions necessarily will depend on judgment calls about an unknowable future.