A Farewell to QE?

By: Jon Faust

October 28th, 2014 1:15 pm

The FOMC has long communicated that, if something like its modal outlook played out, it would likely make one final $15 billion reduction in the pace of asset purchases at its October FOMC meeting, which is now taking place.  This would put an end to the purchase program known as QE-infinity.  In essence, we may be coming to the “beyond” stage of the Fed’s bold September 2013 declaration of “To QE infinity and beyond.”

Most analysts seem to see the end of the program at this meeting as a foregone conclusion, and in this view the main discussion at the meeting will be about how to change the forward guidance for the federal funds rate—guidance that is currently intertwined with purchase program.  Given the momentous effects often attributed to QE, however, I thought it would be worth setting aside the forward guidance issue for a moment and considering a few farewell questions regarding QE.

Would eliminating $15 billion per month in Fed purchases really matter in a multi-trillion dollar market?

The narrow answer is pretty clearly “no.”  The remaining low pace of purchases is too small to have any substantial effects.   There is, however, always a broader answer when it comes to discussing the effects of any Fed action.  This broader answer brings in the vaunted “signaling effects.”  To the extent that the stopping of purchases signals some significant shift in the intended future course of policy, then the action could be associated with very important effects.

Why would the FOMC use the end of the purchase program to signal a significant change in the intended course of policy?

It wouldn’t.  The Berananke and Yellen FOMCs have been pretty clear in word and in deed that significant changes will be discussed, to the extent time allows, at length and before, during and after the change.   The days of deducing significant policy changes from obscure actions or the color of the Chair’s tie are over.  Neither Fed actions with regard to purchases nor the color of the Chair’s scarf will signal a significant change in the intended course of policy. Declared changes in intentions will signal changes in intentions.

At the very least, won’t stopping purchases signal that we are very unlikely to see renewed purchases any time soon—that this tool is used up or back in the toolbox for good?

No.  Every time a purchase program has been concluded, it was concluded with the hope that renewed purchases would never be needed.  This hope will be present when this program ends as well.  Since the crisis, however, whenever inflation threatened to move persistently toward deflation or unemployment threatened to rise to or remain at levels far above normal, the FOMC expressed its willingness to employ “all its tools as appropriate” to promote its dual mandate of maximum employment and price stability.  I would be very surprised if the same were not true today.

It is surely true, however, that the bar for re-starting purchases is higher today than when QEI or QEII ended. The economy is much healthier than when the other programs ended—labor market conditions are better, firm and household balance sheets are in better shape, and financial institutions are healthier.  Further, the balance sheet of the Fed is much larger than when the other programs ended, and each further increase in the balance sheet probably incrementally raises concerns regarding possible unintended consequences.   So the case for further extraordinary measures is arguably weaker at present.  Should that case become strong again, however, asset purchases remain one of the FOMC’s tools, and I suspect that the FOMC remains prepared to use all its tools as appropriate.

So what would the end of purchases signify?

At the outset of QE infinity, the FOMC said that it was looking for a substantial improvement in the outlook for the labor market and would, according to the FOMC statement (Sept. 2012), “continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until such improvement is achieved in a context of price stability.”    Since the FOMC began tapering the pace of purchases, it has regularly indicated that, “If incoming information broadly supports the Committee’s expectation of ongoing improvement in labor market conditions and inflation moving back toward its longer-run objective” further reductions in the pace of purchases would be forthcoming.

I think by any reasonable measure there has been a substantial improvement in the outlook for the labor market since the program began.  (I am not taking a position on how close conditions right now are to “normal;” reasonable people differ on that.)  I’d expect the FOMC to emphasize that the outlook for the labor market is substantially improved, and that the economy more generally is, for reasons noted above, much healthier than when the program began and when the earlier purchase programs ended.   Further, I expect the FOMC to note that its modal outlook for continued improvement in the labor market has not changed dramatically since the last meeting. Despite storm clouds in the form of ebola, weakness in the euro area and China, etc., the modal scenario for economic activity probably remains solid, if unspectacular.

Obviously, the price stability side of the mandate is the greater risk or challenge at present.  Inflation has been running under the Fed’s objective of 2 percent for quite some time now.  And over recent months, a number of transitory forces have emerged that are likely to provide short-term downward pressure on inflation.  These factors include the rising dollar, bumper crops, and falls in the prices of oil and other commodities.  Under the FOMC’s criteria, we might say that any evidence of underlying forces that will, over time, have inflation moving back toward 2 may be masked or offset by transitory downward pressures.   I think it is largely unavoidable that convincing evidence for or against inflation moving back toward two will be hard to come by over the next few months.

In the face of this murky inflation outlook, I expect that the FOMC will, over coming weeks and months, go out of its way to to communicate its strong intention to promote the return of inflation to 2 percent, and, ultimately, its willingness to use all its tools as necessary should inflation threaten to move persistently lower.  For speculators and Fed groupies like me, it will be exciting to see what particular manner the FOMC chooses to communicate its strong commitment to promoting inflation’s return to 2 percent, but for the broader economy, the strength of the commitment is probably most important.  In my reading of the FOMC, the strength of this commitment is unquestionable.

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