Inside The FOMC's Collective Head

Because of its scope and aggressiveness, the FOMC’s open-ended MBS purchase program caught many by surprise, including us. The committee not only extended its forward guidance with respect to the time period during which it intended to keep rates low, it also initiated $40 billion per month in new mortgage-backed securities purchases. To be sure, Chairman Bernanke did indicate at his press conference that when Operation Twist is concluded in December, the Committee will revisit its entire set of asset-purchase programs. But he also unambiguously left open the possibilities for an extension of Operation Twist and more Treasury purchases. This suggestion alone will result in lots of market and pundit chatter as the December FOMC approaches. The FOMC’s decisions have drawn the headlines and attention of the press and commentators. But it is also worthwhile to delve deeper into the details of the projections materials that were released following the meeting.

Connecting The Dots
Perhaps the most interesting detail is contained in what we call the dot chart, which shows the assumed Federal Funds rate by each FOMC participant for each year. FOMC participants submit their forecasts with embedded rate assumptions prior to the FOMC meeting, and those assumptions reflect what they believe to be “appropriate” policy. After each meeting, participants are given the opportunity to revisit their projections and assumptions. However, since only a couple of hours elapse between the end of the formal FOMC meeting and the release of the projections materials at the Chairman’s press briefing, it is not likely that significant changes can be or are made. In addition, because we are now in a regime of quantitative easing, it isn’t known what assumptions have been made in the forecasts concerning the volume, composition, or timing of Fed asset purchases. This is particularly critical now that the FOMC has made a significant change in its program and it is unclear whether the released forecasts include the likely effects of that program. Here is one opportunity for more Fed transparency, and the reason this issue is important will become clearer in a few more lines.

Now, back to the dot charts. The striking thing is that, when compared with the June projection in Chart 1 (http://www.cumber.com/content/special/chart1_forecast_comp.pdf), by September Chart 2 (http://www.cumber.com/content/special/chart2_sept2012.pdf) more of the Committee have fallen into line and appear to be very similar in their policy views. In June three participants assumed a movement of rates from the current policy. For 2013, a total of six (or three more participants) were assuming a movement in rates away from the 0-.25 basis point range; and by 2014, thirteen participants had abandoned that low rate-range policy. However, in the most recent September projection materials, only three months removed from June, just one participant assumed a rate movement in 2012 (most likely this was President Lacker). Only four assumed a rate move in 2013, as compared with six in June; and by 2014, only six assumed a different rate from current policy, as compared with 13 in June.

Why The Change Of Mind?
Clearly, views of FOMC participants have changed significantly and one wonders what kinds of information triggered the tipping point. The economy is continuing to grow, jobs are being added, and housing appears to have stabilized. And the Beige Book, which supposedly accounts for information that postdates the macroeconomic data, fails to reveal a significant decline in economic activity, region by region. The reported noted that “… economic activity continued to expand gradually in July and early August across most regions and sectors.” Nine of the twelve districts in fact reported “modest” or “moderate” growth. Retail activity had increased and real estate markets had improved, while employment was either steady or “growing only slightly.”

The clues to the Committee’s thinking, of course, are in the statement and were explained by Chairman Bernanke in his press briefing. The Committee has become impatient with the slow pace of the recovery and lack of improvement in the unemployment rate. In the face of a benign inflation situation, it concluded that action was needed and could be provided with little or no inflation risk. The key phrase here is in the Chairman’s line “… if we do not see substantial improvement in the outlook for the labor market, we will continue the MBS purchase program, undertake additional asset purchases, and employ our policy tools as appropriate until we do so.”

Reporters at the press conference astutely pressed the Chairman repeatedly both on what the Committee would have to see specifically in the data and on whether the policy change signaled an increased tolerance on the part of the Committee for inflation. On both issues the Chairman bobbed and weaved without providing anything other than “We’ll know it when we see it.” He talked in generalities about “… broad-based growth in jobs and economic activity that generally signal sustained improvement in labor market conditions and declining unemployment.” No hints were provided as to how rapid growth would have to be, or for how long, to meet the Committee’s definition of “broad-based,” nor did the Chairman clarify how the Committee would determine whether observed improvement could be “sustained” or not. The effect of this kind of vague language will likely come back to haunt the Committee when the economy improves and markets and investors are faced with the challenge of determining when and how to change investment strategies. Clearly, market euphoria over this most recent policy move is not based upon either economic or company fundamentals, and this should be worrisome.

The 'When-And-How'
The issue of “when and how” becomes even more significant when one looks at the forecasts that are contained in the projections materials released by the Committee. The September forecasts for 2012-2015 and the intermediate term are compared with previous forecasts in Charts 3-4. http://www.cumber.com/content/special/charts3-4realgdp.pdf The central tendency for GDP growth in 2012 moved down from a range of 1.9-2.4% to 1.7-2%, a slowing not necessarily reflected in the Beige Book. There were virtually no changes for the years 2013-2014, which had moved up to 2.5-3% for 2013 and up to 3.0-3.8% for 2014. Moreover, the first forecast for 2015 has a range nearly identical to that for 2014. Keep in mind that, because there were essentially no changes between June and September in the growth forecast ranges for 2013 or 2014, and there is no difference for 2015, one wonders how to think about the assumed impacts of the asset purchase program. Either the purchases have not been vectored into the forecasts, in which case the projections are essentially useless, or they have been. If the latter, then the FOMC’s own forecasts suggest there will be no substantial impact of the programs on growth through 2015.

As for unemployment Chart 4, no change was predicted for 2012, virtually no change for 2013, and only modest improvement for 2014. Given the growth projections and the lack of improvement in the unemployment rate for 2014, the sudden improvement in the range for 2015 is puzzling indeed. The central tendency range for 2015 dropped significantly to 6.0-6.8%.

The Employment Math
Here is why that forecast is puzzling. On average, we estimate that an economy growing at the rate of, say, 3% will create 161 thousand jobs a month, plus or minus 50 thousand (with 95% confidence). This means that it would take about 29 months on average just to replace the remaining jobs that were lost in the recent recession. Given the conservative position on hiring that businesses have assumed coming out of this recession, the average of 161 thousand jobs created per month is probably optimistic, even with growth at the high end of the FOMC’s assumed range. Additionally, considering that it takes about 150 thousand jobs per month just to absorb new entrants into the labor market, let alone allow for the re-entry of discouraged workers, it stretches credibility to believe that the pace of job creation implied by the GDP growth forecasts can lead to the significant drop in the central tendency for the 2015 unemployment rate in the projections.

In short, the Committee’s decision to embark upon further stimulus programs raises important questions about the usefulness of its projections materials and how changes in quantitative easing policies figure into those projections. The concerns from a policy and markets perspective are the Committee’s views on what the incremental effects of its policy decisions are on the real economy and how and when it will decide that it is time to unwind the period of extreme policy accommodation. Certainly, the materials provided imply a long period of sustained asset acquisitions and a further substantial increase in the Fed’s balance sheet. This expansion will only exacerbate the Fed’s exit problem, and to the extent that it experiences capital losses on asset sales, those losses will accrue to the taxpayer through reduced remittances to the Treasury, and increase the deficit.

Bob Eisenbeis