A Brave New Way of Conducting Monetary Policy

June 21, 2013

As noted in earlier updates, I was surprised by the clumsily handled signal that quantitative easing might soon be throttled back.  It was out of character with Bernanke’s previous stewardship that had managed to limit the duration and depth of the U.S. 2008-9 recession and achieved a sturdier subsequent recovery than experienced either in Europe or Japan.  The violent adverse market reaction afterward was predictable, so much so that I am now led to wonder if that reaction in fact was the premeditated intended result, rather than a mistake that monetary officials might want to take back.  Allow me to explain.

Twenty-first century monetary policymaking has stressed increasingly the role of communication as a whole different and independent policy tool of its own.  Changing interest rates or non-standard policy settings at times of extreme uncertainty and in conditions that have few precedents for guidance are fraught with great downside risk.  It’s harder for policymakers to know what stance is best.  Moreover, if a setting is changed and subsequently seems ill-timed or outright wrong, it’s not easy to reverse the move quickly, because doing so carries the stigma of admitting to the error and thus erodes confidence that monetary officials know how best to guide the economy. 

So at times of high uncertainty such as these, it’s advantageous to orchestrate market changes without actually using central bank levers by simply convincing investors that significant central bank changes are coming, and the more specific officials can be about the likely timing of insinuated action, the more effective will be their bluff.  The Fed was not first to discover this ploy.  ECB President Draghi began his staged unveiling of the Outright Monetary Transactions facility (OMT) almost a year ago, which at the eleventh hour of a runaway crisis seemed destined to break up the currency union beyond all recognition.  Pressures within the region’s banking system immediately began to recede even though the required conditions for using OMT were so strenuous as to make actual use of the arrangement remote by any of the bloc’s peripheral members. 

The market reaction to Bernanke’s suggested downsizing of quantitative easing addresses some of the criticism of the Fed’s ultra easy stance, namely frothy commodity and stock market prices and long-term interest rates that had housing price inflation back in double digits sooner than anybody had imagined.  Like the strict requirements that must be met before OMT can be used, Bernanke left himself an escape hatch that enables him to renege on a strongly suggested fundamental near-term change in central bank policy.  The decider of future fed policy will be future economic trends and how those trends shape the Fed’s outlook for employment and inflation.  If the market continues to act with strong confidence that QE will be changing in September, the situation likely will change sufficiently by then for officials to scrap the current QE reduction timetable.

Copyright 2013, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.

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