When Will The Fed Act And What Will It Do?

The short answer is that it will do nothing today. But that hasn’t deterred pundits from speculating. What we know is that the FOMC, as a policy-making body, has been fairly clear that its main focus is on employment. It seeks to get unemployment down to 6.5% before it will begin to reverse its policy course. The one proviso is that it may act sooner should inflation start picking up.

Attempts to parse the public statements of FOMC members and participants for additional information only confirm two things. First, the vast majority of those who vote are solidly in the camp of maintaining accommodation until the labor market improves. Equally important, there are no hardline, or even moderate, inflation concerns represented by the seven current members of the Federal Reserve Board, all of whom are voting members on the FOMC. Moreover, FOMC members have been especially clear – and this is emphatically the case with Chairman Bernanke – that the 6.5% number is only a “guidepost” and not necessarily a trigger. Broader considerations will enter into the decision-making process, which means that the when and how of FOMC moves will be heavily data-dependent.

All of this aside, speculation is rampant about when the Fed will begin to taper off its asset purchase program or, for that matter, expand purchases further should the economy falter or signs of deflation appear. That speculation was given life as FOMC participants in their public statements began to discuss a more gradual and phased exit from the current monetary-policy accommodation, in contrast to the initial indications in the FOMC's June 2011 statement on its exit strategy that simply talked about an abrupt cessation of its asset purchase program.

Here is the problem the FOMC faces in crafting either a phased asset purchase program or changing the interest rate it pays on reserves. Two things must happen for a phased asset purchase program to work. First, the FOMC must have confidence that even a modest change in the program won’t cause a stampede to the door by fixed-income investors who seek to avoid capital losses. Second, conditional upon what the FOMC sees happening in the economy, it has to know what the impulse responses are likely to be to changes in its asset purchases in order to calibrate its policy.

We see the risks of an abrupt sale of fixed-income securities from portfolios and an accompanying sharp jump in interest rates as the most likely response to any indication on the part of the FOMC that the music is about to stop. Moreover, there is no experience or data that would allow the FOMC staff or the Committee to make meaningful inferences about the likely effects that alternative paths for asset purchases might have on the economy or employment. In response to a question on this very point at the recent Financial Markets Conference sponsored by the Federal Reserve Bank of Atlanta, Chairman Bernanke indicated that they might be able to make inferences from their asset purchase program. But the purchase program was put in place in pieces when the economy was in the doldrums, so there is no reason to assume that the market responses or impacts of a phasedown of asset purchases would have a symmetric effect.

A similar problem exists with regard to changes in interest rates paid on reserves. To have the desired effect on either inflation expectations or the expansion of the money supply, the FOMC must have reliable estimates of the elasticity of demand for reserves. Again, meaningful estimates don’t exist.

The bottom line of this discussion is that we expect that any change in policy, be it changes in asset purchases or otherwise, will be very cautiously undertaken and likely to err on the side of waiting until the employment situation is unambiguously positive, which is far from the case at this point. Furthermore, any moves that are made will be incremental and experimental. In other words, trial and error will likely rule the policy response.

BY Bob Eisenbeis