This Fed Is the Economy's Hero
Here’s the most important thing anybody can tell you about the taper: It’s not the taper that matters, but the signal the taper sends. By the same logic, the Federal Reserve’s decision today to delay the taper matters little on its own. What counts for everything is the signal: This Fed is committed to restoring vigorous economic growth.
The Fed currently buys $85 billion in bonds each month. If the Fed defers the taper until its December meeting, that adds at most $255 billion extra to its balance sheet for an extra three months. That’s a trifling amount -- less than a tenth of its total assets and maintained for a trivial amount of time. So the specific month should have no impact.
What makes it matter is the information the taper reveals to investors and businesses about the future path of monetary policy. A Fed that’s ready to taper now, the logic goes, is one that’s on the margin more hawkish. It’s willing to raise interest rates sooner and more quickly, even amid unimpressive economic conditions. That the Fed has decided to delay the taper implies a more dovish “reaction function” for the coming years.
If this sounds like too much extrapolation, you haven’t been watching the markets over the last three months. Or, for that matter, reading the latest work of monetary economists.
Michael Bauer and Glenn Rudebusch, economists at the San Francisco Fed, found in a recent paper that as much as half of the impact of bond buying comes from this signaling effect. And Northwestern professors Arvind Krishnamurthy and Annette Vissing-Jorgensen came to similar conclusions. Announcements of quantitative easing, they found, shifted expectations of interest-rate increases months into the future and sharply depressed yields on shorter-term bonds.
It shouldn’t be surprising that expectations matter. Few participants in the economy care what the federal funds rate is this month, but almost every household and firm makes decisions based upon its expectation of the trend of interest rates over the coming decade.
The best evidence that the taper delay sends a broader signal, though, is the changed language of the Fed’s statement itself. It “decided to await more evidence that progress will be sustained before adjusting the pace of its purchases.” And it will time the taper based upon “whether incoming information continues to support the Committee's expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective."
Whatever economic conditions it's seeing now, in other words, aren’t good enough to justify a taper. That’s a big change from what everyone had thought. Everyone was ready for a Fed that was ready to settle. The Fed just showed everyone that it isn’t.
The real news of the taper, then, isn’t a few more months of asset purchases. It’s that this is a Fed that finally expects more out of the recovery than the “meh” we’re seeing now.