Fed Repudiates Its Own Economists

Academics and Fed researchers had been reaching a consensus that asset purchases don't do much for the economy. Today's decision repudiates that consensus.

The Federal Reserve has decided not to reduce the pace of its asset purchases because of concerns that the economy is too weak to handle even the slightest withdrawal of monetary stimulus. At the same time, the Fed refrained from adjusting the "thresholds" that will affect when it may start raising short-term interest rates. Together, these decisions are a repudiation of the emerging consensus on optimal Fed policy.

As I explained earlier today, Fed researchers and top outside academics are coming around to the view that the Fed's purchases of U.S. Treasury bonds don't actually do that much for the economy. Instead, they argue, the real action comes from something called "forward guidance." That's when Fed officials tell traders what factors will affect the future path of short-term interest rates. At first, the Fed simply promised that it would keep short rates near zero until a given date on the calendar -- a date that kept getting pushed further and further into the future.

Then, in December, the Fed announced that it would not raise short-term interest rates as long as unemployment remained high and inflation remained tame. According to informed analysts and connected academics, this was a significant step toward a regime in which the Fed no longer needed to use asset purchases to move markets and affect the economy.

Why? Well, Fed officials were becoming increasingly wary of the negative side effects associated with their bond-buying. As Columbia's Michael Woodford explained to me last week, the Fed needs to start tapering its asset purchases immediately -- irrespective of labor market conditions -- because there is a limit to how much it can buy without disrupting the financial system. To offset the perception that this tapering constituted a tighter monetary policy, the Fed could modify its policies regarding short-term interest rates.

This context makes today's decision rather surprising. Fed Chairman Ben Bernanke and his colleagues have doubled-down on asset purchases as a tool to stimulate the economy and told us nothing new about the path of short-term interest rates. Intriguingly, the markets don't seem to mind. Gold, emerging market currencies and equity prices soared. Bond yields plunged.

Does this mean that academics like Woodford and the Fed's researchers are wrong? Does it mean that traders are silly and overreact to meaningless noise? Or does it mean something else? It will be interesting to watch how the Fed continues to react to the incoming data in its subsequent meetings.

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