The Puzzle of the Fed's Tools

Matthew C. Klein writes for Bloomberg View about the economy and financial markets. He previously wrote for the Economist magazine and its economics blog, Free Exchange.
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It's that time of year -- no, not the holidays, but the last meeting of the Federal Reserve's Open Market Committee before 2014. Nowadays the nation's monetary policy makers aren't disagreeing as much about whether the economy needs more or less stimulus. Instead, they are being forced to grapple with far knottier problems relating to the tools at their disposal.

Just consider quantitative easing. When the Fed first bought government-guaranteed mortgage-backed securities during the worst of the crisis, it was acting as a market-maker. Everyone else was selling, and the Fed stepped in to stop the panic, so the impact was unambiguously positive. More recent rounds of purchases seem to have been less helpful, while everyone nervously awaits news of when they will end. Of course, the Fed was supposed to be done buying bonds by the time the unemployment rate had fallen to 7 percent (its current level), so who knows what will actually happen.

Many of the smartest analysts now wonder if asset purchases actually make consumer prices riseslower than they would otherwise -- a position increasingly supported by the data. The Fed's preferred measure of inflation has been slowing ever since the beginning of 2012. The slowdown might be a temporary phenomenon unrelated to Fed policy, although that doesn't explain why the market's implied inflation forecast for the next five years is lower than it was before the Fed started its most recent round of bond-buying in September 2012.

Five-year breakeven inflation rate between U.S. Treasury Inflation Protected Securities and U.S. Treasury notes. Source: Bloomberg.

From this perspective, the Fed may actually end up giving the economy a needed boost if it decided to cut its asset purchases. Alternatively, it could end up killing the housing market. According to research by Bank of America Merrill Lynch, the Fed is funding a large and rising share of new mortgages. The accompanying table shows the total value of new mortgage-backed securities issued by the government's housing agencies relative to the Fed's purchases of those securities.

The Fed is buying a rising share of the securities issued by the government's housing-finance agencies. Source: NY Fed, Bank of America Merrill Lynch Global Research.

It isn't clear how the Fed can extricate itself from its bond-buying without upending America's quasi-nationalized system of housing finance.

The other big question for policy makers is what to do about short-term interest rates. Prices of eurodollar futures contracts indicated a significant tightening of Fed policy over the summer. Future short rates have fallen since then, although Fed policy is still expected to be tighter three to five years from now than it was six months ago.

Prices of December 2015, 2016 and 2017 eurodollar contracts. Source: Bloomberg

One possibility that was discussed at the last meeting -- and recently endorsedby Alan Blinder, a former vice chairman of the Federal Reserve -- would be a cut to the interest paid on bank reserves held on deposit at the Fed. This misguided plan would destroy money that would otherwise flow to the broader economy via the banking sector without increasing credit creation. That helps explain why interest on reserves hasn't been lowered.

Others at the FOMC are fans of telling traders what to expect, using so-called forward guidance. The Fed has been experimenting with this for a few years, most recently by saying that it won't raise interest rates as long as unemployment is higher than 6.5 percent and inflation remains quiescent. The minutes of the previous FOMCmeeting revealed a lack of consensus on what to do when the unemployment threshold is breached, as it almost certainly will be well before the central bank's 2 percent inflation target is reached. It's hard to see how increased communications and clearer guidance will be helpful, given the Fed's internal disagreements, uncertainty about the outlook, and the willingness of several FOMC members to change positions on a dime in response to new data.

It's unclear how much these debates matter. Many traders are already on vacation, or will soon be departing, so it's unlikely that the Fed will make any major policy changes before New Year's. And many FOMC members, including Chairman Ben Bernanke, are headed out the door. Since none of the data suggest an urgent need to adjust policy now, rather than in January or March, the big decisions will probably be left to their successors.

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