E-piphany

On Friday, the long-awaited Jackson Hole speech by Ben Bernanke finally happened. With bated breath, investors waited for news of his oration.

Unfortunately, most investors don’t speak “Fed,” so it was manifestly unclear, or clearly unmanifest, what the Chairman was necessarily getting at. Some investors seemed to be expecting him to say “start the choppers, boys, and let’s light this candle.”

Well, that’s not how Fed Chairmen…or economists…or humans, except for Nicolas Cage…speak. But what Bernanke actually said is still fairly clear to those who have listened to Fedspeak for a long time. An important part of Fedspeak is that the speaker assumes the listener is completely aware of the context, and the subtext, of his remarks. So let us forget our predispositions for the moment, about what the FOMC may decide next month, and dispassionately analyze the arguments currently before the Committee – which constitute the context in which the Chairman delivered his remarks.

The doves, when given the floor at the meeting in mid-September, will say that growth remains unacceptably slow, and that whether the Fed would like to or not, they are not permitted to ignore one leg of their dual mandate. They will observe that year-on-year core PCE for July was just announced at 1.6%, below expectations of 1.7% and well below the March high of 2.0%, which also happens to be the Fed’s target. Although this is likely a temporary phenomenon, the doves will argue that it doesn’t matter if it is; what it means is that they have at least 3-6 months before core PCE could feasibly be much above their target, and perhaps 9-12 months before it could be alarmingly so. The doves will argue that the tail risks to growth are now heavily to the downside. Unmentioned, but a further subtext, will be the recognition that a Romney Presidency is no worse than a coin flip at this moment, and the institution might find itself constrained if it should desire next year to take aggressive action on growth – and if the party of Romney wins, it is likely to also lead to reduced fiscal stimulus, or even a fiscal drag. Finally, they will observe that money supply growth has slowed to only 5.7% on a 52-week rate of change basis, and even corporate credit growth may be slowing (up 5.4% y/y, but only 3% over the last quarter), so that any easing action would be adding fuel to a low fire, not to a roaring blaze.

What is the hawks’ rejoinder, when it is their turn?

The economy is sputtering, but it isn’t actually contracting. Housing prices, which had been the economy’s albatross, seem to have turned higher and inventory is clearing. Previous aggressive monetary policy has not produced very much other than lofty asset prices, and has skewed markets; moreover, there remains a wall of money out there that threatens large future costs and small future benefits. The best arguments that the hawks seem to have, at the moment, is that there are large costs to future action and few benefits to be gained. They can’t win on current inflation – it is too low. They can’t win on current growth – it is too low. They are unlikely to win on asset prices that aren’t affecting consumer inflation, and that many investors don’t see as ‘bubbly.’ They can’t win on the ‘balance of global growth risks.’ They can’t very well argue that fiscal policy should do more when the balance of power in the Executive and Legislative branches is up in the air. The only potentially winning avenue they have is if they can argue that it isn’t worth the risk to add more money, even though adding lots of money to date hasn’t produced runaway inflation. To this end, William White at the Dallas Federal Reserve[1] (where President Fisher is generally to the hawkish side of the ledger) recently posted a white paper entitled “Ultra Easy Monetary Policy and the Law of Unintended Consequences,” which specifically argues that the long-term costs outweigh the short-term benefits of ‘ultra easy monetary policy.’

Now, with this context, let’s look at Bernanke’s speech. Bernanke is not unaware of White’s paper, and he is aware that everyone else in the roomful of economists is aware of White’s paper. He is aware that the hawks rely on this argument, and he cannot leave the topic unaddressed.

So Bernanke includes in his speech a section entitled “Making Policy with Nontraditional Tools: A Cost-Benefit Framework.” In it he declares that “the FOMC carefully compares the expected benefits and costs of proposed policy actions,” but adds forcefully that “The possible benefits of an action, however, must be considered alongside its potential costs.” He then describes the potential costs, as he sees them, of large-scale asset purchases (LSAPs). (It is interesting, as an aside, that he focuses on this one possible policy action.) And he ultimately argues that – and this is the key phrase in the whole speech, as far as I am concerned, given the context and subtext:

 “The costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.”

Thus, Dr. White, you are duly answered. We thought about it, and the costs are manageable. Thanks for writing.

Having dismissed that argument, Bernanke sets up the doves’ arguments. Not surprisingly, they are the same as the arguments presented at the August FOMC meeting, which surprised many observers when the minutes were recently released. The Chairman said, predictably, that “Unless the economy begins to grow more quickly than it has recently, the unemployment rate is likely to remain far above levels consistent with maximum employment for some time.” And he concluded with “the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.”

None of this means that the Fed will ease for certain, and I am on record as saying that I think they shouldn’t but will. Bernanke’s speech today strongly suggests to me that they will do something, and since the list of meaningful somethings is very short at the moment, it will likely be one of three things.

1. LSAP of some kind, perhaps in mortgages instead of or in addition to Treasuries.
2. Lowering of IOER – less likely, although smarter. It’s also possible they could nudge IOER lower just slightly, as was recently suggested.
3. Changing the formulation of the ‘extended low rates’ promise, so that it is no longer a date but rather a hard formulation of the Evans Rule that has been in place in a ‘soft’ form since June.

I don’t think that just extending the ‘end date’ for the low rates pledge is a viable option. First, it would disappoint investors, who are expecting something more concrete from the Fed, and thus wouldn’t have the intended effect anyway. Second, many Fed officials have grown uncomfortable with the box they have put themselves in with a hard date that may or may not coincidentally line up with the evolution of economic variables. Third, most investors recognize it’s not a promise anyway, so it has little value.

I believe the Chairman has made clear (or as clear as he is likely to make it in a speech to economists) that more QE is coming, and if I had to order the three options above I would say (1) is most likely, (3) is next-most-likely, and (2) is least likely. Indeed, I think that since the Committee will likely not want to move at the next meeting, which will be quite close to the election, I think there’s a chance they could do some of all three of these.