Federal Reserve policymakers have gathered to begin a two-day policy meeting, and it isn’t just the weather that's gloomy. But will the central bank respond to a softening economic picture by pumping more money into the economy? Almost certainly not, and the reasons why have some important implications for where Fed policy is heading.
None of the most recent major economic indicators have signaled a real strengthening of the economy: Jobs, GDP, retail sales and various manufacturing surveys have been muted. Inflation is coming in below the 2 percent that the Fed aims for, as it has persistently through this sluggish recovery; over the past year, the consumer price index is up 1.5 percent. But if I had to judge the likelihood of getting more easing out of the Fed by looking at one, and only one, chart, it would be this one:
The graph charts expected annual inflation over the next five years, as reflected in bond market prices for inflation-protected versus regular Treasury bonds. The Fed’s ability to affect the job market is hazy and uncertain; but the central bank’s control over inflation expectations is stronger. Many Fed officials who are reluctant to make bond purchases to try to lower unemployment are more open to it as a protection against deflation. As the chart shows, the Fed’s easing actions over the last three years (QE2 in November 2010; “Operation Twist” to shift the Fed portfolio toward longer-term securities in September 2011, QE3 in September 2012; and guidance on thresholds for unemployment and inflation levels that the Fed wants to see before raising interest rates, in December 2012) have each come after significant drops in these inflation expectations.
Well, it’s happening again. Five-year inflation expectations fell from 2.4 percent in mid-March to 2.07 percent today. So, will the Fed step in yet again to try to reverse the fall?
It's very unlikely they'll decide to buy more bonds to boost growth this time around. That's partly because they don’t want to overreact to what appears to be only a soft patch in the economy rather than a new turn toward stagnation or recession. And even with the drop in expected inflation, the number is still at (actually a bit above) the Fed’s 2 percent target. During past rounds of monetary easing, markets had been expecting inflation below 2 percent.
But the Fed has other reasons to be reluctant to expand the $85 billion-a-month in bond purchases even if economic data disappoints.
First, Fed leaders have been sensitive to the risk that through the quantitative easing they could completely take over the market for U.S. Treasury debt. One of the United States’s great long-term economic strengths is that Treasurys is the deepest and most liquid financial market on earth, a key part of the dollar’s role as the global reserve currency. If the Fed bought so many Treasury bonds that other buyers were squeezed out, could it do permanent damage to the Treasury market, with lasting consequences for the U.S. economy and financial system? If you're a top Fed official, you really don't want to risk it.
As deficits fall, the U.S. government doesn't issue as much new debt as in the recent past, which, meaning that the Fed’s purchases are accounting for a growing portion of the market. In the first three months of the year, the U.S. Treasury issued an average of $62 billion per month in coupon Treasury notes on net (that is, new bonds issued minus those that matured) according to data from Sifma. That's down from $82 billion a month at the start of 2012. The Fed has been buying $45 billion in such longer-term Treasurys each month. That is an uncomfortably high proportion, many at the Fed believe.
The Fed also bought $40 billion in mortgage-backed securities, and in theory the central bank could lean heavily on those purchases, which help directly lower mortgage rates. But that would push the Fed closer to allocating credit in the economy, as it would be favoring housing over other sectors.
That reluctance to take over the Treasury bond market pairs with another reason the Fed will be reluctant to increase bond purchases even if the economy worsens. The views of Michael Woodford, which the Columbia University political economist explained in a much-cited paper from last year’s Jackson Hole symposium, has gained traction among economists inside and outside the central bank: Maybe quantitative easing doesn’t affect the economy so much on its own terms, by pushing money into the financial system. Maybe it is more important as a communications tool, to signal the Fed's commitment to preventing deflation and setting overall economic activity back on track.
If you as a central banker agree with Woodford, and believe that the economy needs the maximum possible help, you have every reason to keep buying bonds for as long as possible to reap those communication benefits: Every extra month you prolong quantitative easing, you are continuing to signal to markets and economic decision-makers that the central bank is committed to doing what it takes to get the economy back to its pre-recession state. If total QE is going to add up to, say, $1.1 trillion, then you'll be reassuring the country for longer if you are buying $70 billion in bonds a month instead of $85 billion.
That helps explain why even some dovish members of the Federal Open Market Committee (John Williams of the San Francisco Fed, vice chairwoman Janet Yellen) began talking about tapering bond purchases after the March policy meeting. And it also tells us that the Fed probably won't be so quick on the draw to pump up QE3 unless inflation expectations and growth indicators fall a lot further.