The minutes of the 24-25 January FOMC meeting confirm that committee-members judged there had been little change in economic conditions from their 13 December meeting. The US labour market had continued to strengthen but the improvement was characterised as gradual and unemployment remained elevated. Some members noted that much of the decline in the jobless rate in recent months had reflected a fall in the labour force participation rate, which might be reversed if the recovery continued. There was lively discussion of the significance of detailed aspects of the data.
Some argued that high levels of long-term unemployment pointed to a mismatch between skills and available jobs, rather than to a shortfall in demand, whereas others cited subdued wage growth as a sign that a large degree of slack persisted in the economy. Since members reckoned monetary policy was already ultra-accommodative, as befitted a situation in which the economy faced headwinds, they saw no need to take fresh policy-actions and turned, instead, to consider how they might improve the Federal Reserve's communication strategy.
Prior to this meeting, financial markets had seen some chance the Fed might resume its outright purchases of long-term assets (QE3). Specifically, they had mulled the possibility that the FOMC might choose to support the housing market by approving an expansion in the Fed's holdings of mortgage-related securities. In the event, though the committee saw general housing conditions as still being depressed, some members mentioned causes for limited optimism in a decline in the inventory of unsold homes, firmer land prices and easing credit standards in the mortgage market.
On balance, 'a few members' observed that current and prospective economic conditions could warrant additional securities purchases before too long. But 'other members', presumably the majority, believed such action 'could become necessary' if the economy were to lose momentum or inflation seemed set to undershoot a 2% rate over the medium term. One member, Mr Lacker of the Richmond Fed, believed that pre-emptive policy-tightening would be needed to keep inflation close to 2%.
The FOMC's discussion of communication strategy showed how transparency is not always synonymous with clarity. Last year, there was an important innovation in the statement the FOMC regularly releases after its policy meetings with the inclusion of a passage providing specific forward guidance on the federal funds rate. Two participants at the January meeting expressed concern that some press reports had misinterpreted the FOMC's reference to a date in its forward guidance as a commitment regarding its future policy decisions. Yet, we might object, without this misapprehension there would be little point in the FOMC mentioning a date at all. It is hardly credible that Mr Bernanke and his colleagues would have been content if markets had reacted to the FOMC's January decision to extend the forward guidance on 'exceptionally low rates' from mid-2013 to late 2014 by dismissing it as a mere forecast or, worse still, a pious wish.
Policymakers were relying on markets interpreting the statement as offering a degree of assurance, stronger than a forecast could provide, that exceptionally low rates would persist to late 2014. Only on that interpretation could they hope that their forward guidance would be effective in exerting downward pressure on yields in the 1 to 3-year maturity-range. Indeed, if forward guidance were not intended to influence market behaviour in this way, it is hard to see what advantage there would be in issuing it.
The problem is that the latest step in the evolution of FOMC communications, publishing members' individual views on the appropriate future level of the funds rate, tends to undermine any assurance that forward guidance may be aiming to instil. In recognition of this inconsistency, 'several participants' at the January FOMC meeting proposed dropping or greatly simplifying the forward guidance given in the statement. However, several other FOMC members advanced the highly revealing argument that information about funds rate forecasts in the FOMC's Summary of Economic Projections (SEP) 'could not substitute for a formal decision of the members of the FOMC'. What exactly, we might well ask, have members formally decided to do, when the committee publishes forward guidance on the level of the funds rate.
If they have not decided to pre-commit on interest rates, it is difficult to see why these members are talking in terms of a 'formal decision'. Yet publication of individual interest rate forecasts in the SEP has shown that support in the FOMC for the forward guidance on the funds rate falls well short of wholehearted commitment. Further, since individual FOMC members forecast the other economic variables incorporated in the SEP on the assumption of 'appropriate monetary policy', their differences over what would constitute an appropriate monetary policy mean that their economic forecasts are not comparable. The 'central tendencies' derived from these forecasts may be unreliable as a guide to how members believe those variables will actually perform. In short, confusion reigns.
The markets' attention has focused on whether the FOMC will soon launch a QE3 exercise. However, the committee has good reason to be satisfied with the results so far of its maturity-extension programme, known as Operation Twist. In terms of its effects on long-term markets, this programme has an impact similar to that of QE. At the same time, it tends to underpin the yields of the shorter-dated assets the Fed is selling, thereby creating opportunities for banks to profit from borrowing short to lend slightly longer.
The Fed achieves all this without courting controversy by inflating its own balance sheet any further. The current Operation Twist is due to be completed by June. If the FOMC deems then that more monetary support for the economy is warranted, it seems more likely to aim for this by extending its 'Twist' operations than through more QE.
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