How an improving economy makes new Fed policies more potent

October 22, 2012

Federal Reserve Chairman Ben S. Bernanke and the rest of the Federal Reserve policy committee gather again this week for what is sure to be a less dramatic meeting than last month, when they unveiled a new program of bond buying to try to drive down unemployment.

But while major changes in policy will probably be scarce when the Federal Open Market Committee unveils its handiwork Wednesday afternoon, the events of the six weeks since its last big change have shown the real importance of the Fed’s new approach to policy.

The economic data has improved since that Sept. 13 announcement. At the time of the meeting, for example, Macroeconomic Advisers (which has an economic forecasting model similar to that used internally by the Fed) estimated that third-quarter gross domestic product rose at a 1.5 percent annual rate; now it estimates that number to be 2 percent. The unemployment rate plunged to 7.8 percent in September from 8.1 percent in August. Housing starts, retail sales and consumer confidence numbers have all soared.

That improvement would seem to call into question the rationale for the Fed’s decision to pump $85 billion a month into the economy, commonly known as QE3 because it is the third round of “quantitative easing.” Maybe growth is stronger than Bernanke & Co. realized at the time of that meeting, and they were faked out by a few months of bad data.

Quite the contrary. Even leaving aside that some other indicators of the economy’s recent performance aren’t so hot (particularly measures of business investment and hiring), the uptick in growth could make the Fed’s decision even more potent.

A key part of the Fed’s new strategy last month was to announce that the FOMC “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” In other words, the central bank aimed to assure the world that it would not pull away the support strut of low interest rates until the economy was well along in recovering, so long as inflation doesn’t threaten to get much above the Fed’s 2 percent target.

It was a deliberate effort to undo a pattern that had been in place for the last three years of weak economic recovery. Whenever there has been a quarter or two of decent growth, investors have started speculating about the exit, seeing the interest rate hikes by the Fed as being just around the corner (and some of the more hawkish members of the FOMC have certainly aided that cause, showing eagerness to hike rates sooner rather than later).

But now, with the new assurances from the Fed, bond markets don’t seem to be as jittery as they once were. The day of that good jobs report in early October, for example, the yield on 10 year Treasury bonds rose only 7 hundredths of a percent (or basis points); the day of the good retail sales report it rose less than one basis point.

Those are pretty small moves for pretty big pieces of economic information. The way to interpret it is investors aren’t so worried that a few months of good news are going to bring a sudden onset of tight money.

In normal times, the presence of the Fed amounts to something of a buffer for the financial markets and the economy. When there is bad economic news, stocks and other financial assets don’t decline as much as they otherwise might, because investors know that interest-rate cuts from the Fed have become more likely. The strange policy environment in which the Fed now finds itself — with its short-term interest rate target near zero for four consecutive years, with likely a few more on the way — has lessened that role. Instead, the Fed’s unconventional tools to ease policy have consisted of big interventions, launched with much hand-wringing and only after months of weakening economic data.

Now, when bad data cross the financial wires, investors are more likely to interpret the information as a reason to think the FOMC will continue its purchases of $85 billion in securities each month a little longer, which buffers the downturn in markets. And when good data cross the wires, they don’t leap to the conclusion that the Fed is going to soon back away.

For those who think that new purchases by the Fed are necessary and proper to get the economy back to robust growth, that amounts to a victory for the Fed’s new policy. People who see the bond-buying as a risky action that will stoke financial bubbles — well, they can find evidence for their view, too; the markets are again seeing the nation’s central bank as a salve for their wounds.

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