Fedspeak on Both Sides of the Atlantic

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Federal Reserve Chairman Ben Bernanke and New York Fed President William Dudley both took to the podium yesterday. Dudley spoke directly to the current intersection between the economic outlook and monetary policy, while Bernanke took on the topic of monetary policy in a global context. Despite coming from different directions, both were supportive of current policy.

Dudley first, as it seems journalists are seeing the speech with somewhat different eyes. Jonathon Spicer at Reuters walked away with:

New York Fed President William Dudley, a close ally of Fed Chairman Ben Bernanke, gave a strong and comprehensive speech defending the very easy monetary policies that he said were gaining traction and must not yet be adjusted.

Spicer concludes from the speech, accurately I think, that it is consistent with expectations that the Fed will continue large scale asset purchases at the current pace for the foreseeable future (most of this year, by my expectations). Notable was Dudley's view of the labor market. From the speech:

So how are we doing relative to our objective of a substantial improvement in the labor market outlook?...The unemployment rate is modestly lower and private non-farm payroll growth a bit higher...other important indicators including the employment-to-population ratio and job-finding rates are essentially unchanged...This suggests that the labor market is far from healthy.

Moreover, our policy is based on the outlook for the labor market, not the level of employment or unemployment today. In this context I note that the recent improvement in payroll employment growth, which gets much of the attention, is out-sized relative to the growth rate of economic activity that supports it. We have seen this movie before...As a result, it is premature to conclude that we will soon see a substantial improvement in the labor market outlook.

The implication for policy:

Currently we are falling well short of our employment objective and the restrictive stance of federal fiscal policy is a factor. On inflation, we are also falling short, but by a considerably smaller margin. As a consequence, we need to keep monetary policy very accommodative.

I do not claim that there are no costs or risks associated with our unconventional monetary policy regime. But I see greater cost and risk in moving prematurely to a policy setting that might not prove sufficiently accommodative to ensure a sustainable, strengthening recovery...

Seems to be a clear indication that he is not inclined to alter the pace of asset purchases in the near future. At a minimum, Dudley is looking for evidence that the recent acceleration in job growth is sustainable (in concert with improvement across a broad range of indicators), and I think that will come only after another six months of nfp numbers consistently 200k+.

Other journalists took a different focus. The headline of Victoria McGrane's Wall Street Journal piece is:

Fed Banker Backs Dialing Down Easy Money

Something of a hawkish tone, no? From the article:

A member of the Federal Reserve's inner circle Monday promoted a plan for the central bank to scale back the pace of its bond-buying program as the jobs market improves, though he stressed that a decision on how to proceed is far from imminent.

Similarly, Robin Harding's Financial Times piece is titled:

Dudley gives first hints of slowing QE3

Again, something of a hawkish take. Harding's lead-in:

One of the Federal Reserve’s biggest backers of easy monetary policy said he supported the slowdown of the central bank’s asset purchases once the US economy had enough momentum.

I think these headlines imply that the end of quantitative easing is closer than conventional wisdom holds. I don't think that should be a takeaway. But these articles focus on another takeaway, that the Fed is coalescing around a plan to taper-off asset purchases, not end cold-turkey. From Harding's piece:

The comments by Bill Dudley amount to the first official hint that the pace of a reduction in the asset purchase programme – known as QE3 – is likely to be gradual, and may soothe market worries about the impact of reduced purchases by the Fed.

Back to the speech:

In my view, we should calibrate the total amount of purchases to that needed to deliver a substantial improvement in labor market conditions, by allowing the flow rate of purchases to respond to material changes in the labor market outlook...At some point, I expect that I will see sufficient evidence of economic momentum to cause me to favor gradually dialing back the pace of asset purchases.

Given the current outlook, FOMC members do not anticipate increasing the size of asset purchases. The discussion will thus naturally turn toward the other direction - when and how should we end asset purchases? I think Harding is correct to conclude that a consensus is building within the Fed to taper-off purchases gradually, but only after the sufficient progress is made on the labor market front. But be wary of losing focus on the latter point. Even if the Fed know how they want to end the asset purchase program, that time is still far off given the current forecasts.

Dudley added an interesting footnote to the last sentence I quoted above:

Assuming that the improvement in the outlook is not endogenous to the chosen policy setting to the extent that it would disappear if purchases were slowed.

This suggests that it is not enough that the labor market makes sufficient progress to justify changing policy. The Fed also has to be confident that the progress is self-sustaining in the absence of quantitative easing. It seems to me that this raises the bar for slowing asset purchases.

Separately, Bernanke took on the issue of the so-called currency wars. After a history of exchange rate policy during the Great Depression, Bernanke concludes:

The lessons for the present are clear. Today most advanced industrial economies remain, to varying extents, in the grip of slow recoveries from the Great Recession. With inflation generally contained, central banks in these countries are providing accommodative monetary policies to support growth. Do these policies constitute competitive devaluations? To the contrary, because monetary policy is accommodative in the great majority of advanced industrial economies, one would not expect large and persistent changes in the configuration of exchange rates among these countries. The benefits of monetary accommodation in the advanced economies are not created in any significant way by changes in exchange rates; they come instead from the support for domestic aggregate demand in each country or region. Moreover, because stronger growth in each economy confers beneficial spillovers to trading partners, these policies are not "beggar-thy-neighbor" but rather are positive-sum, "enrich-thy-neighbor" actions.

Obviously, Bernanke rejects the currency war story, at least as far as it applies to developed nations. What about less-developed economies? The story is a bit more complicated. Bernanke notes that developing nations may be relying on an export-based growth strategy and may have underdeveloped financial sectors that leave them vulnerable to capital inflows. Bernanke responds that trade-weighted exchange rates are little changed since 2008, and that stronger developed nation growth helps exporters in developing nations. In addition, with regards to capital flows:

It is true that interest rate differentials associated with differences in national monetary policies can promote cross-border capital flows as investors seek higher returns. But my reading of recent research makes me skeptical that these policy differences are the dominant force behind capital flows to emerging market economies; differences in growth prospects across countries and swings in investor risk sentiment seem to have played a larger role. Moreover, the fact that some emerging market economies have policies that depress the values of their currencies may create an expectation of future appreciation that in and of itself induces speculative inflows.

Notice that at the end he hits the ball back to the currency manipulators? Furthermore, he advocates considering capital controls:

Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.

Again, Bernanke is pushing the conversation back onto his critics. Developing nations have tools to address their concerns. Use them.

Bottom Line: The Fed is not thinking about expanding the pace of asset purchases. Instead, they are thinking about when and how to end those purchases. Policymakers anticipate a gradual end to the program, and they want to communicate their intentions well ahead of the actual timing of the policy change. So expect them to continue to walk a fine line between acknowledging the exit strategy while making clear the exit is not imminent. Finally, Bernanke continues to brush off critics, both home and abroad.

Source: Tim Duy's Fed Watch

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