Thursday, March 15, 2012

Federal Funds and the Paradox of Conditional Promises

The Fed’s Open Market Committee met on Tuesday and issued a statement. What changed in this statement compared to the Fed’s previous statement? Here’s what I think is the most important change. On January 25, the Fed said:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.


On March 13, the Fed said:

In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.


See the change? What, you don’t? You must have forgotten to put on your X-ray vision goggles!

There is a change, but it isn’t visible to the naked eye. At least it’s not visible if you just look at the words. What we have here is a case of the shifting relationship between signifier and signified.

Suppose your spouse calls from work and says, “I’ll be home in two hours.” Then an hour later, your spouse calls again and says, “I’ll be home in two hours.” The words are the same, but the meaning has changed: changed enough, perhaps, to make the difference between a hot dinner and a cold one. The phrase, “in two hours,” is the same, but the time to which it refers has changed.

In the Fed’s statement, what has changed is the referent for the word “conditions.” I just looked at a chart of the Citigroup Economic Surprise Index, and one thing I note is that, for the past six weeks (and for some months before that), it has remained consistently positive, and indeed consistently above +35, indicating that we have been receiving positive economic surprises. A rational forecaster will not be expecting the same conditions between now and 2014 as they had been expecting on January 25. Logically, if the conditions expected today are likely to warrant the same thing as conditions expected in January were likely to warrant, then the Fed must have changed its idea of what kind of conditions would warrant that.

By repeating the language in its earlier statement, the Fed has in effect announced a change in its reaction function. If the Fed had an explicit economic target for the next three years, it would have to change that target in order to continue being consistent with the language in its statement. By apparently doing nothing, the Fed has eased monetary policy.

Now the effect of an easing of monetary policy is that the economy is likely to be stronger than what was likely before the easing. After all, that’s the whole point of easing monetary policy. And that’s where things get tricky.

What does the Fed’s statement, implying that it expects to keep the federal funds rate low, mean about the likely actual future path of the federal funds rate? It means that the federal funds rate is likely to rise sooner than you previously expected. By promising – quite sincerely – to keep the federal funds rate low, the Fed is increasing the chance that the economy will call its bluff and force it to raise the federal funds rate. This is the paradox of a conditional promise.

It’s similar to the argument I made a couple of years ago with respect to bond yields (and which, in that case, the subsequent experience of QE2 seemed to bear out). Somewhat like the way the leader of a cartel can push prices up by threatening to cut prices if anyone defects, a central bank can raise bond yields by threatening to cut them. A similar logic applies to the federal funds rate, even though, in this case, the rate is under the Fed’s (almost) direct control. By specifying a more stringent criterion for raising the rate, the Fed actually increases the chance that the criterion will be met.

Think about it this way. Suppose the Fed had an explicit economic target such as nominal GDP. The Fed’s repetition of its “likely to warrant” language, in the face of an improved outlook, is like an increase in its nominal GDP target. If the Fed had such a target, and if it increased the target, what would you expect the effect to be on interest rates two-and-a half years hence? Surely a higher target would mean that future interest rates are likely to be higher rather than lower.

If you ask me for my best guess, I still expect that the Fed will most likely end up sticking to the late 2014 timetable. After all, we did have the worst recession in 70 years and have barely started to recover even three years later. And under current law, federal fiscal policy is scheduled to drive directly into a brick wall next year. But the Fed’s repetition of its “likely to warrant” language, because it makes me a little more confident in the economy, makes me a little less confident in my prediction about the federal funds rate.

UPDATE (4/25/2012):  Fed projections (PDF) issued today call my whole argument into question.  Looking at the participants' assessments for the "appropriate timing of policy firming," while the median date is the same as in January, as reflected in the statement, the average has declined, with some of the 2016 "ultra-doves" having moved back to 2014 and 2015.  Meanwhile, the improved outlook for 2012 is largely offset by a weaker outlook for 2013 and 2014.  So it is not clear that there is any change in the Fed's reaction function.



DISCLOSURE: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management. This article should not be construed as investment advice, and is not an offer to participate in any investment strategy or product.

44 comments:

Steve Roth said...

But couldn't the Fed just be saying, "Right now we're exactly where we expected to be two months ago. We saw this coming. So our projection for the future from now forward is also unchanged. So our language is unchanged from two months ago."

??

Andy Harless said...

Steve, yes, in theory the Fed could be saying, "So there, you dumb private sector consensus! We knew all along you were too pessimistic. Glad you have now come over to our point of view." There are a few reasons I don't think that is the right interpretation. For one thing, the language elsewhere in the release suggests that the Fed does think the outlook has improved. For another, between November and January, the Fed revised its economic projections downward, so it would seem to be coming off a fairly pessimistic baseline when we compare the hypotheical March forecast to the one made in January. Finally, I just think that the working assumption, unless you have a reason to think otherwise, should be that the Fed's outlook is similar to that of the private sector, given that the Fed has only a little bit of inside information.

Steve Roth said...

Yeah, those things all make sense. Thanks.

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The words are the same, but the meaning has changed: changed enough, perhaps, to make the difference between a hot dinner and a cold one.

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