What Is the Fed Thinking?

Evan Soltas is a contributor to Bloomberg View.
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The Federal Reserve is trying to figure out its next move. Monetary policymakers have promised to continue monthly purchases of $85 billion in mortgage and U.S. Treasury securities. But after their latest meeting they added an important, yet little-noticed, point: The Fed "is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes."

It's a curious sentence, because several Fed officials have already come forward to explain how the Fed would exit its bond-buying program. An increase hasn't been on the table. Observers expect that, given steady progress on unemployment and tame inflation, the Fed will reduce bond purchases over the course of several meetings, beginning in the fourth quarter. It will probably hit pause after that -- and wait for the unemployment rate to fall below 6.5 percent, consistent with its "Evans rule" commitment. Then the Fed can begin to raise its policy rate as well -- in 2015, as it has indicated.

Recent data have complicated the Fed's decision. Hiring seemed to slow at the start of the year. That caused concern -- but the figures have been revised upward. Growth in gross domestic product has been bumpy and generally slower than the Fed had hoped. Inflation is slightly, but persistently, below the Fed's target.

What else is the Fed watching? What news and what sorts of numbers will convince its members that they can withdraw stimulus -- or that they need to extend or even boost their injections?

Payroll employment. The Fed has tied policy to the unemployment rate, now at 7.5 percent, but officials understand its limitations. (The rate falls when workers are so discouraged they stop looking for work, for instance -- hardly a sign of progress.) They could be looking for three to six months of growth in payroll employment of 200,000 or more each month. That could be the "substantial improvement in the labor market" they have in mind.

Inflation. The Fed's preferred measure of inflation, the annual change in the PCE price index, stood at 1.0 percent in March. The Fed keeps an eye on other price indexes, too, and they all suggest that near-term inflation could run below target. The "core" PCE price index, which excludes volatile food and energy prices, rose by 1.1 percent. The consumer price index, and its corresponding "core" variant, are both slightly below 2 percent. Another measure of "core" inflation known as "trimmed-mean inflation" -- obscure to the public but closely monitored inside the Fed -- stands at 1.4 percent and is poised to keep falling.

More than is recognized, the decision to exit may ride on inflation. James Bullard, the president of the Federal Reserve Bank of St. Louis, said recently that the Fed should hold fast to its "price stability" goal, and that inflation has lately fallen too far below target. If inflation drops below 1 percent -- a psychologically significant threshold -- there'd be strong internal pressures to increase bond purchases.

Sequestration. The Fed is unlikely to trim its bond-buying until the macroeconomic impact of sequestration is clear. The Congressional Budget Office, as well as private economic forecasters, expect it will be by the fourth quarter of 2013.

A policy of "wait-and-see" makes some sense. Federal spending, adjusted for inflation, was falling by 2 percent a year before sequestration came into effect. Government employment, too, has been dropping by roughly 10,000 per month. That might not seem much -- but it's enough to knock a whole percentage point off the annual growth of GDP. The Fed would likely delay its exit if it believed sequestration was having a bigger effect on growth than it expects. The CBO thinks that the cuts will bring GDP growth down by 1.5 percentage points, but it's very uncertain.

GDP. The Fed is likely to discount the last two quarters of GDP growth because, as Neil Irwin has put it, the first quarter's moderate strength is the flip side of a truly anemic fourth quarter. The average of the two is slow: growth of 1.45 percent. But the Fed may prefer, in effect, to set both quarters aside and give the second-quarter number more than usual weight. That number comes out on July 31, with revisions in late August and September. If the number comes in low -- say, less than 2.5 percent -- then discussion of policy tightening will likely be postponed until the Fed has an advance estimate of third-quarter growth, on Oct. 30.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Evan Soltas at esoltas@gmail.com