The Fed and the Skittish Financial Markets

March 1st, 2014 at 10:47 am

Allow me to vent for a sec before getting all rational again.

I’m fed [sic] up with all of these arguments that the Federal Reverse’s foremost client is the financial markets, and Janet et al better be careful not to upset the bond traders what with all their whacky data-driven macro-management.

OK, vent over (and, really, a pretty wonky and tame vent, I’d say).

This morning’s papers are abuzz with Fed-watchers reporting on a new paper that focuses on the market risks associated with aggressive monetary policy.  While targeting weak demand, the analysis argues, the Fed creates market volatility that is inadequately addressed by “forward guidance,” i.e., when the Fed telegraphs its thinking about its future actions.

The “taper tantrum” from the summer of 2013 is exhibit A in this rap.  The Fed says the obvious—um…at some point we’re going to start unwinding our historically unprecedentedly high balance sheet—and market’s freak, as Ylan Mui eloquently puts it:

The Fed had been buying $85 billion in long-term bonds each month to stimulate the economy. But several top Fed officials suggested in public remarks that the Fed could soon begin to scale back the purchases – triggering fears that years of easy-money policies were coming to an end.

The bond market freaked, sending the yield on the 10-year Treasury spiking to 3 percent. That rippled into the real economy as mortgage rates shot up, threatening the recovery in the housing market.

Her last point is well taken, and connects the bond market to the real economy showing that this matters more than my initial rant implies.  Yet, mortgage rates were also going to go up, and they remain quite low in historical terms (average for 30-yr fixed since 2000: 5.7%; last week’s rate: 4.4%); still, their rise has slowed the housing recovery a bit.

The problem with this argument, however—that Fed macro-management increasingly incurs market volatility—is that it disallows a critically important position of the central bank right now: the idea that they will be data driven.  To be so means that Janet and co. are reserving the right to adjust course if need be, based on incoming data.  She’s been careful to underscore caution in this regard—they’re not going to lurch with every dip in the data—but neither can they be a slave to market skittishness.

We want a Fed that transparently yet flexibly pursues its dual goals of full employment and price stability (I’d add bank regulation, but that’s a different discussion).  The weight right now must, of course, be on full employment, as Chair Yellen has consistently–and recently–emphasized.   The recovery has been shaky and inconsistent, and there’s at least a hint, I’d say a not insignificant one, of another head fake in store.  If so, the Fed should alter its course, suspend the unwinding or more, once again targeting growth and jobs.  It should and will do its best to explain its moves to the markets with as much advance as possible.

But it can’t be hamstrung by a fear that markets will react unfavorably, as they are but one of its clients. And right now, in terms of who’s reaping the benefits of what growth we’ve seen, I’d say they’re the lesser client.

[Endnote: To be fair, the paper itself–link above–is pretty measured in this regard: “…the tradeoffs for monetary policy are more difficult than is sometimes portrayed. The tradeoff is not the contemporaneous one between more versus less policy stimulus today, but is better understood as an intertemporal tradeoff between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”  But my analysis still holds–the interpretation of this concern in the hurly-burly of monetary policy in the real world raising the potential risk of less aggressive targeting of output gaps.]

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7 comments in reply to "The Fed and the Skittish Financial Markets"

  1. Dave says:

    “the Fed creates market volatility”

    Actually that is impossible. Market players create market volatility. Nothing the Fed does can be construed as volatile. We need to send the financial industry to rehab.

    But I wonder sometimes if we shouldn’t send the entire economics profession to rehab also. There is a lot of denial floating around.

    With regard to the taper talk, I thought it should have been obvious what was going on here. The data I saw convinced me that the taper talk was effective at partially squelching a new housing bubble. However, the Case-Shiller index shows we still have a growing housing bubble again, and I view that as a disaster in the making.

    So what was the main effect of the taper talk? To understand that, we need to understand what was happening in housing before the taper talk. Essentially, the Fed’s buying up of MBS’ to lower mortgage rates directly, while creating some temporary stimulus, it was also creating an investment bubble that was fundamentally different that the first housing bubble. It was clear to me that investors with cash were buying up housing with that cash as a speculation that the Fed was willing to create a new housing bubble to increase AD.

    As soon as cash-rich investors heard the talk of taper, they left their speculative positions. The actually effect upon homebuyers and home sellers was unnecessary volatility, but it was caused by cash-rich investors, not the Fed.

    Nevertheless, we have a growing bubble in housing even in the face of excess housing inventory. I suspect this is largely due to regional effects. Specifically, I mean places like Detroit and Ohio are not recovering while other markets that were previously healthy are bubbling out again.

    This is a mess of epic proportions.

  2. Dave says:

    Just one other issue related to this.

    At the beginning of the Clinton administration, James Carville made this statement: “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

    Unfortunately, it is the fault of our politicians and prominent economists for allowing the intimidation to take place. Nobody can be intimidated unless they allow themselves to be intimidated.

    I think we’ve learned a lot over the years, and it was probably a genuine intimidation that administration officials felt due to their lack of full understanding. It has become clear to me that very few people understand our system, and that it has functioned as a series of mistakes, a process of trial and error, with almost nobody possessing the full picture.

    On top of that, there has been so much money at stake, and there are a lot of investors that knowingly perpetuate the notion that the government must bow to investors. It just isn’t true.

    It is time to put the financial industry into submission! The people need to take control of the government, and the government needs to take control of the financial industry. If they do that, the Fed can be made to work properly again. If we don’t do this, the “free market” system will destroy itself. Of this I am certain.

  3. Kevin Rica says:

    I’ve said this before and I’ll repeat myself again.

    It’s the same people who gave us the New Classical/Rational Expectations theories that markets couldn’t be fooled by the Fed and government policies, who now claim that markets are easily panicked by any ill-considered or unkind word from the Fed or government officials — the rational agents of the free market will spook and jump off a cliff in the face of any policy uncertainty.

    Can’t have it both ways!

    BTW — This Sunday’s Doonesbury nails it.

  4. Tom in MN says:

    I think that the Fed should have let the noise of the data into their process. By leaving the amount of purchases fixed for a long time it became a big deal when they even talked about changing it. If instead they had been adjusting the purchases by $5B or so with every change in the data, then when the changes started to add up in one direction over a few meetings or they moved to a change of $10B, it would not have been a new and unknown concept that spooked the markets. The $85B number was just a guess to start with, so they should have been adjusting it to try to find the correct amount as part of the process. What they did instead gave the impression that this was a key amount and $75B was drastically different, which it was not.

    They are stuck with exactly the same problem at the first raise of interest rates at “lift off.” I hope they wait until we have clear inflationary pressures to do this (I’d like to see wage inflation — as I’m sure you would, which won’t happen at 2.5% inflation) or they may slow growth again. But they did not have to create the same problem with their QE program.

  5. dilbert dogbert says:

    Just a picky picky on your article. Please don’t use Janet when referring to the Fed Chairman. I don’t think Ben was used when referring to Mr. Bernanke.
    Yes I am a guy who notices such usage. Sort of like the use of “boy” when speaking to or about a black person.

    • Jared Bernstein says:

      FTR, I referred to “Ben and Co.” many times. Google “jared bernstein ben and co.” and you’ll see what I mean.

  6. Peter K. says:

    Part of the problem is the corporate press, the Washington Post in this case. Ylan Mui echoes the message the authors of the paper are putting forward

    “Stimulus is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted,” they write.”

    There’s no free lunch in economics! Well maybe we could settle for avoiding disasters like 2008 and the failed austerity policies of 2010 onwards instead of reaching for free lunches.