Janet Yellen’s first press conference and FOMC meeting did not go off as smoothly as she and others might have liked. In her first attempt to explain the direction of Federal Reserve policy, Chairwoman Yellen said that the current quantitative easing program would probably cease later this year around October 2014. Following the end of the taper, Chairwoman Yellen hinted that interest rates could begin rising around six months later around April 2015. This date was much earlier than most Fed watchers expected rates to possibly rise. So was this a mistake? Or was her comment an intentional redirection of Fed policy? Both Greenspan and Bernanke were remarked as having rough entrances to the job, and occasionally they used the Board of Governors to help them backtrack on comments.
These comments were in relation to her explanation of why the Fed had dropped their earlier use of forward guidance. Unfortunately many former Fed officials and other economists are confused about why the Fed has not been more specific about what is guiding their thinking into 2015-2016. The ‘conventional’ thinking that there is a single inflation rate that should be hit has been challenged by those supporting overshooting as described in The Economist (and a second related article) (even though overshooting is usually reserved for other uses). Now, the Fed as led by Yellen might actually be acting in what appears to be a conventional way by claiming to target a specific inflation rate while acting some other way. What is it that we think the Fed is actually doing?
Has the Fed suddenly become more hawkish on inflation? What would the Fed have to do about their balance sheet in order to tighten policy? Some of the increase in QE/Base has clearly gone to support emerging markets. What effects do you expect on foreign markets, and therefore back on the US?
Questions you might answer:
- Many of the questions you can look at were posed above in the text. Look there for suggestions, or bring your own analysis of Yellen’s recent comments during her press conference or the most recent FOMC meeting announcements.
9 thoughts on “ECON430-Topic #3: A Difficult Job?”
I believe Yellen’s “six month” comment was deliberate in order to better prepare the economy for inevitable interest rate hikes that will come following the end of QE. Since 2008 when the Federal Reserve started paying 0.25% interest for excess reserves, the amount of excess reserves kept at the Fed has risen from barely any to around $2.5 trillion. When the inevitable happens and the interest rates do rise, then banks will no longer have incentive to keep their excess reserves at the Fed because they will be able to get a greater return making loans with the higher interest. If the market is not prepared for all this money to flood into it, then we could experience massive inflation which would also push interest rates up. To prevent inflation the Fed would then have to start selling bonds, but again this would push the interest rates up. Yellen also qualified her “six month” comment a great deal mentioning that lots of things like the labor markets and inflation will ultimately go into the decision of the exact timing of the interest rate hike. While I don’t believe that the hike in interest rates will happen exactly 6 months after the ending of QE, I do believe that Yellen wants the market to be prepared for it to happen and so she gave that general time frame.
I found Yellen’s first conference online and watched it. It basically didn’t disclose anything new. We previously knew the Fed is going to end the QE soon, and the market already anticipated the Fed fund rate will hike around the middle of 2015. However, when Yellen made a comment on the future date of the hike on interest rate, she made it clear that nothing is set in stone. It’s the media hyping made it such a big deal.
I believe the sky-high $2.5 trillion excessive reserve deserves much more attention, and that’s the true “sword of Damocles” we should worry about. The Fed has been imposing rate on reserve to ensure a stable economy, and this policy clearly helps the Fed postpone inflation that would have been caused by the QE. However, since interest rate will increase soon, banks will be much more willing to lend out those “once-reserves” money and make a profit out of it, and this massive liquidity will be a tremendous shock on world economy. Leaving the liquidity injection alone may result in major inflation, and I believe the Fed will not compromise on their long-term target inflation of 2%. In this case, the Fed will perhaps have to sell bonds even more aggressively in order to drain those excessive reserves, and the interest rate hike follow-up will probably result in a new round of Wall Street strike-back. Hence, I think the most plausible way to get out of this mess is set up some government-guaranteed lending program, just like what we (U.S.) did during 1930s when we encountered a similar excessive reserve problem. A program such as refinancing student loans, which would draw down the monetary base, but would not expand the monetary supply, might be a good choice. However, the fact that the anticipated Fed fund rate hike will begin during 2015, which approaching election year of 2016, makes me grow concerns about U.S. government’s ability to set up and monitor massive program(s) timely and seamlessly to the shock.
I believe that the Fed should end the quantitative easing program sooner rather than later as the new Fed Chairman Janet Yellen suggested. The artificially low interest rates that have been a result of this program have lead to a dramatic increase in the level of high risk, high yield investments. This is a direct result of the extremely low interest rates, which allows for the creation of cheap debt. Thus investors are using this cheap debt and investing in risky assets in an attempt to gain high yields. This can lead to miss priced assets and in turn result in the creation of bubbles in the economy. Junk bond sales have been increasing dramatically, for example they increased 24% in the first six months of 2013. The strong quantitative easing program the Federal Reserve has been using is creating an environment in which investors are taking on far too much risk, which once the Fed does indeed end the easing could have negative consequences. With that being said, I believe the Fed should end the easing before more of this risky investing occurs. The stimulus program is a policy that should be enacted in a time of crisis, something that the United Stated is no longer in.
One interpretation of Yellen’s response about the interest rates rising sooner than expected is that it could be an intentional redirection of Fed policy. If the Fed believes the economy will be stronger than the general consensus, this could explain an interest rate rise sooner than expected. According to Dr. Jeremy Siegel, “The market interpreted the news from the FOMC indicating that the Fed would have to raise interest rates a bit more aggressively than earlier forecast, not because of the fear of inflation, but because they believe economy is going to get stronger.”
During Yellen’s comments, she reiterated the Fed’s commitment to 2% inflation, and also defended their decision to drop the 6.5% unemployment rate (U3) as their threshold for ending quantitative easing. She stated that the FOMC was evaluating “many more things” in determining the strength of the labor market. In addition to the Fed’s 2% inflation target, these variables likely include economic growth and the broader U6 measure of unemployment. The Fed may not be able to be as specific as many economists would like, perhaps because they may not have this equation fully defined themselves, and they want to maintain flexibility.
jeremysiegel.com – weekly commentary 3/21/14
Janet Yellen’s first press conference may not have gone as smoothly as some may have liked, however, I believe that this was just used as an act of misdirection in Fed policy. This is because as quantitative easing begins to come to an end, the Fed will be buying fewer bonds causing the demand to fall along with the prices of bonds to fall. As bond prices fall an inevitable effect of this is going to be for interest rates to rise. By telling people that interest rates are going to rise sooner than previously expected she is preparing the economy for the increase in the interest rate. Preparing the economy for this increase in interest rates which is bound to happen helps because if people expect interest rates to rise they will take appropriate actions. This includes selling current bonds because increasing interest rates change consumers preferences from bonds to holding cash. If people do this before the increase in interest rates then the rise in inflation due to increase in cash holdings will last only until the interest rates actually do rise and people can reinvest in bonds as they now provide a larger yield to the holder. Since Inflation raises the interest rate as well, this prevention of an increase in inflation will prevent the interest rate from increasing more than it could.
Ben Bernanke’s original issuance of “forward guidance” and the FOMC’s guideline to not even think about rising interest rates until the unemployment rate reached 6.5% felt like a long time when issued in 2012. Last year, however, the unemployment rate dropped dramatically and is now on track to hitting 6.5% in around October of this year. With Janet Yellen’s comments about a 6-month gap between the end of the Fed’s asset purchases and the first interest rate hike, that would make the first interest rate increase in April of 2015; much earlier than previously expected. The market reacting negatively to this news, the Dow dropped about 150 points immediately following the press release and the bond markets experienced a major sell-off.
I believe Yellen’s comments were necessary and the market overreacted. With $2.5 trillion in excess reserves currently being held, banks have no incentive to loan out their excess reserves with interest rates at such a low level. Once the interest rate begins to rise, this vast amount of liquidity entering into the system would have extreme consequences on price inflation. Thus, by issuing a small comment in a press conference about the impending interest rate hikes, Janet Yellen is inadvertently preparing the economy for the release of the bank’s excess reserves. What Janet Yellen plans to do about that liquidity still remains the issue.
Reading Too Much?
After Federal Reserve Chair Janet Yellen’s controversial comments about rate increases, many have been speculating whether the Fed has changed direction. Some say we are going to see rates increasing faster than predicted, others say we are entering a period of inflation targeting. What if we are simply putting too much consideration to the Chair’s comments? When she was asked about when rates would hike, she responded after three, ‘you know’ by saying, “it probably means something on the order of around six months or that type of thing.” Unless she is a master of deception, how could this ambiguous comment actually be taken seriously? Based on her stumbling of words, this comment was probably more of human error than a policy shift. Markets may have declined on March 19th, but most quickly rebounded the next day. Bernanke even made some timing errors, especially with the beginning of tapering.
The takeaway from the Fed shouldn’t be a radical change in policy, but rather the credibility of the Fed. Considering we are debating over a simple comment should indicate that we do not take everything a Chairman (or woman) says at his/her word. The one consistent trend with Yellen and Bernanke’s comments is that the Fed’s course of action changes based on the economy. The two credible words that we can trust the Fed as far as monetary policy is, “it depends.”
What effects do you expect on foreign markets, and therefore back on the US?
Thanks to quantitative easing programs and low interest rates in the United States, there is a huge flow of capital running into emerging markets to find increased profits. Santanu Chakraborty who works at Govt. of India said that overseas investors have purchased a net of $17.7 billion of Indian equities during 2013. These capitals help companies to have more money in order to create more jobs and force goods to be exported from emerging markets. Besides, the value of assets in emerging markets increases, which is beneficial to asset holding investors in emerging markets. For example, over the past six months, India’s stock market has gained nearly 6 percent although quantitative easing programs begin tapering. Large Asian stock markets are gaining even more attention with stocks in India attracting $2.4 billion in net cash while investors in Taiwan stocks added $1.3 billion during March, 2014, stated by Mike Burnick (Money and Markets). Quantitative easing programs have increased and have helped improve the balance sheets of large central banks in emerging markets. They help emerging markets overcome toxic debts and remain stable during the crisis. However, when the current quantitative easing program ends and the US government raises interest rates, a lot of the outflow of capital from emerging markets will return to the US market. Actually, Wei said that “when Ben Bernanke announced this past June that if the economy stayed on track the Fed would begin to pull back on its quantitative easing later in the year, the S&P 500 immediately dropped 5.5%.” Also, Mike Burnick said “only Thai stock market, investors responded by withdrawing $3.8 billion from Thai stocks from November 2013 through the end of last month, Feb 2014.” (Follow the Money Flows to Emerging Asia). That will push governments of emerging countries to raise interest rates to stem the outflow of capital. Thus, it can cause macroeconomic instability in emerging markets and growth in emerging markets will meltdown in the next few years. For example, from May 2013 until now, there have been about 14 billion dollars withdrawn from South Eastern of Asian stock market. This would cause financial markets to go into meltdown. Massive capital outflows from emerging markets, with asset deflations and exchange rate falls, which could lead another economic crisis in emerging markets. The US market is also affected in how its bond and stock markets will sell off. Thus, we can take time to see stable economic growth after a great recession in 2008. That will not lead to another recession in emerging markets.
However, the quantitative easing program helped the US economy recover more quickly, lowering unemployment rates and increasing the export of goods. Currently, the US economy is recovering because the unemployment rate is very low at 6.7% now. The unemployment rate hasn’t reached its 6.5% target because those who are unemployed may be structurally unemployed, so it is beyond the reach of the Fed’s help. Interest rates have been low for the past six years and bank balance sheets have been cleaned up by the removal of toxic assets. As, Chris Isidore said on CNN that “Mortgage rates fell to record low levels once again last week, as the Federal Reserve’s decision to buy billions in home loans for the foreseeable future helped bring lending costs down for home buyers and owners” Thus, when the quantitative easing program ends, it can prevent to distort investment decisions and lead to an asset buddle. Besides, this policy also prevent fuel inflation and weaken the value of the U.S. dollar.
Chakraborty, Santanu (Dec 6, 2013). India’s Sensex Posts Second Weekly Gain Before Poll Results, from http://www.bloomberg.com/news/2013-12-06/india-s-nifty-index-futures-swing-before-state-election-results.html
Elliott, Larry (Dec 15, 2013). 2013 Why the Federal Reserve must taper quantitative easing before Christmas, from http://www.theguardian.com/business/economics-blog/2013/dec/15/federal-reserve-scale-back-quantitative-easing-christmas
Noor, Jaisal (Feb 10, 2014). Tapering of Quantitative Easing Is Throwing Emerging Markets Into Chaos – and Big Banks Are Getting Richer, from http://www.truth-out.org/news/item/21777-tapering-of-quantitative-easing-is-throwing-emerging-markets-into-chaos-and-big-banks-are-getting-richer
Fed Chairwoman Yellen announced recently that the annual inflation rate target is judged to be at 2 percent, however over the past year, inflation has been below 1.2 percent on average. Yellen also hinted that, in the near future, short term interest rates will rise. So the question persists, what exactly is guiding the Fed’s thinking?
What one needs to understand is that this target rate is for a period at some point in the future. Basic macroeconomic theory tells one that interest rates and inflation are inherently tied together. Therefore one can infer that the inflation rate in the short term may be higher than the 2 percent annual target rate, given hints that the short term interest rate will be higher.
Nevertheless, Fed officials are comfortable with the fact that inflation will gradually rise towards their 2 percent target level because of firm U.S. inflation expectations and solid U.S. growth outlook. U.S. economic growth picked up in the second half of last year, while the unemployment rate has dropped from 10 percent in 2009 to 6.7 percent as of last month. These facts can lead one to believe that there is little slack remaining in the labor market and that inflation will rise.
Yellen countered these beliefs, pointing to the fact that the drop in unemployment is partly due to discouraged workers leaving the labor market. The unusually large proportion of long-term unemployment and part time American workers seeking full time employment suggests that thinking there is little slack in the labor market may be incorrect.
Therefore it is justifiable that former Fed officials and other economists are confused about why the Fed has not been more specific with what is guiding their thinking into 2015-2016. In a comparative context, as Mark Wahlberg said, “My theory on Feds is that they’re like mushrooms, feed’em s**t and keep’em in the dark”