Sunday, October 31, 2010

The US central bank acts

Only one day after the Congressional midterm elections, the US central bank is likely to announce another round of large scale Treasury purchases. The volume of the initial program will probably be USD 300 to 500bn, with the Fed explicitly retaining the option for further purchases. As reasons for this move, Fed Chairman Bernanke has in recent weeks repeatedly cited “too low inflation rates“ and a ”too high unemployment rate“. To push yields even lower, the Fed could also modify key passages of its press release. Chairman Bernanke said last week that ”a step the Committee could consider […] would be to modify the language of the statement in some way that indicates that the Committee expects to keep the target for the federal funds rate low for longer than markets expect.” 

That would probably mean that the mantra so far– that the Fed would hold interest rates at this extremely low level ”for an extended period“ – will be modified. One possibility would be to state a particular period of time that rates would remain low (as done, for example, by the Bank of Canada); another option would be to make the first rate hike contingent on the development of specific data (e.g. once the core inflation rate has risen to 2% or the unemployment rate has fallen below 7%). If such a change in the Fed’s communication would succeed in pushing back market expectations for the first rate hike even further, this would also lower long-term yields. A further option to reduce real yields that the Fed discussed at its latest FOMC meeting was directly influencing inflation expectations. One possible strategy to raise inflation expectations would be to directly target the price level rather than price changes, i.e. the inflation rate, as done so far.10 We do not, however, believe that such a step will be resolved at the upcoming FOMC meeting.

European conditions?
A (justified) criticism of Europe often heard here in the US is that there is no political unity in the monetary union. The focus is on national interests, with the result that Brussels’ ability to act is limited to key issues – put in other terms: the willingness to reach a consensus is often lacking in many countries. At the same time, the crisis in Greece has shown that when push comes to shove the ECB is indeed able to act. Interestingly, a similar constellation now appears to be emerging in the US. While the dominant interests here are not national but
partisan, the outcome is the same: fiscal policymakers are limited in their ability to act (are unwilling to act), while the US central bank is taking action. The people least happy about this constellation appear to be the central bankers themselves. The regional Fed Presidents Fisher (Dallas), Hoenig (Kansas City), Kocherlakota (Minneapolis), Lacker (Richmond) and Plosser (Philadelphia) have, for example, stressed repeatedly in recent weeks that an even more expansive monetary policy is hardly a suitable tool to resolve the problems currently facing the US economy. They point instead to the unsustainable path of fiscal policy, the aforementioned uncertainty about taxes and healthcare costs, as well as the lack of flexibility and the wrong skills of many unemployed. Finding sustainable solutions to these problems would be the mandate of fiscal policy in Washington. But the impending political gridlock means that any progress in these areas is far off for the time being.

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