Some thoughts on the Fed, QE3, and Financial Markets

Let's take a look back at some of the economic news from this week.  First, in response to some turmoil in financial markets, several members of the FOMC tried to clarify the remarks Ben Bernanke made following the Fed's most recent meeting while some commentators complained that Bernanke was not clear and the Fed had a communication problem.  Fed members said what Bernanke meant was that the Fed plans to begin reducing QE3 (tapering) once the economy strengthens further, using a 7% unemployment rate as a guidepost.  Tapering isn't immediate, but would probably begin later this year, assuming Fed forecasts turn out to be correct, and QE3 will completely end next year.  They emphasized that it's data dependent, so if the economy is weaker than expected, QE3 would continue for a longer period of time.  They also emphasized that tapering shouldn't be confused with an increase in the federal funds rate, which is unlikely until 2015.  How does this differ from what Bernanke said (see previous post)?  What he said was basically:

The Fed plans to begin reducing QE3 (tapering) once the economy strengthens further, using a 7% unemployment rate as a guidepost.  Tapering isn't immediate, but would probably begin later this year, assuming Fed forecasts turn out to be correct, and be QE3 would completely end next year.  It's data dependent, so if the economy is weaker than expected, QE3 would continue for a longer period of time.  Tapering shouldn't be confused with an increase in the federal funds rate, which is unlikely until 2015.
 
If you can't tell the difference, that's OK; they just repeated what Bernanke had already said.  From my perspective, it was hard to misinterpret Bernanke (there must have been some hidden signal; saying that rates would rise in 2015 probably meant 2014, ...).  Why didn't the Fed just say tapering would begin in September (or December) and QE3 would end in June 2014?  Because QE3 is designed to strengthen the economy and reduce unemployment.  If it needs to be in place a little longer to achieve the goal, it'll be extended (tapering beginning in 2014 instead of late 2013, etc.).  So making tapering of QE3 dependent on the state of the economy makes perfect sense.  As a reminder, I'm a skeptic of QE3 (see here and here), so I'm not defending the policy.

So why did markets react they way they did to Bernanke's hints in May and his remarks following the most recent Fed meeting?  First, let me point you to a post prior to the Fed's meeting about rising real interest rates.  Since QE3 involves Fed purchases of bonds, some investors thought it would be a good idea to buy the bonds before the Fed did (since demand from the Fed would increase bond prices, it makes sense to buy the bonds first so you can benefit from the price increase).  Also, negative real interest rates caused many investors to seek better returns in riskier assets.  Once the reality sunk in that QE3 wouldn't go on forever and interest rates started to increase, these trades reversed.  As a result, interest rates spiked and asset prices declined, particularly on riskier assets such as emerging markets.  I don't think this represented investors thinking that the Fed going to end QE3 immediately or increase the federal funds rate soon, but instead represented the unwinding of speculation.  There's a lot less speculative excesses in financial markets now compared to a month ago, which is a good thing for the future (makes new bubbles less likely). 

What is the likely impact of the spike in interest rates on the economy?  That will be addressed in a future post.  What's the key takeaway from what's happened in financial markets in recent weeks?  In an era of record low interest rates (near zero on safe assets), many investors took on greater risk than they would normally prefer in order to achieve a higher return.  The reality of QE3 ending at some point in the foreseeable future along with the subsequent increase in real interest rates caused investors to better appreciate the riskiness of their investments, which is a good thing over time (though it may hurt in the short run).

Inflation Targeting

Following today's meeting, the Fed annoinced that it adopted a policy of inflation targeting, with a long-term goal of 2% inflation.  This formalizes the informal target already employed by the Fed and follows the pattern of many other central banks around the world (Australia, Canada, New Zealand, United Kingdom, Euro area, etc.).  In most cases, their goal is also 2% inflation (or close to 2%).

Some may ask - why not 0%?  There are several reasons, but perhaps the biggest is the fear of deflation.  Once it takes root, deflation is hard to stop and tends to lead to a cycle of economic weakness (think Japan or the US' last bout with deflation - the Great Depression).  Most central banks in developed countries have chosen to target a rate of 2% to provide a cushion against possible deflation while maintaining a low and stable inflation rate.  Unlike most other central banks that target inflation, the Fed continues to have a dual mandate of maintaining full employment; something only Congress can change.

There are several ways to estimate inflation.  The one chosen by the Fed is the personal consumption expenditure (PCE) index, which has been recognized by most economists as the best gauge of consumer inflation since, among other reasons, it reflects recent spending patterns as opposed to an old survey (like the consumer price index).  It's important to note that this policy does not mean the Fed will seek to keep inflation at 2% all the time, but instead will seek to keep inflation close to 2% per year over time.  For example, if energy prices experience a temporary spike, causing inflation to temporarily rise above 2%, the Fed may not respond if it anticipates inflation will return to its target.

By the way, one of the leading proponents of inflation targeting has been Ben Bernanke (link to article by Bernanke from 1997).  Despite what many in the blogosphere think, Ben Bernanke has been a long-term advocate of low and stable inflation.  That doesn't mean his policies are perfect, but he is not seeking to implement policies that result in high inflation.