William C. Dudley, the president of the Federal Reserve Bank of New York, has come out with the most forceful and clear commentary on what the Fed intends to do in the months and years ahead after Chairman Ben Bernanke's press conference last week sparked a global market sell-off. There's only one way to interpret Dudley: Markets got it wrong.
Markets interpreted Bernanke's comments that the Fed expects to begin reducing the pace of its monthly bond purchases later this year as a sign that the era of easy money is ending. And they reacted accordingly: The stock market fell sharply, interest rates rose steeply, and almost every market around the world, from crude oil to obscure currencies, was affected.
Dudley spent a significant chunk of his speech Thursday at a regional economic press briefing in New York, ticking off the ways in which the Fed's policy still tilts toward easy money.
The FOMC’s policy depends on the progress we make towards our objectives. This means that the policy —including the pace of asset purchases — depends on the outlook rather than the calendar. The scenario I outlined above is only that — one possible outcome. Economic circumstances could diverge significantly from the FOMC’s expectations. If labor market conditions and the economy’s growth momentum were to be less favorable than in the FOMC’s outlook — and this is what has happened in recent years — I would expect that the asset purchases would continue at a higher pace for longer.
Second, even if this scenario were to occur and the pace of purchases were reduced, it would still be the case that as long as the FOMC continues its asset purchases it is adding monetary policy accommodation, not tightening monetary policy. As the FOMC adds to its stock of securities, this should continue to put downward pressure on longer-term interest rates, making monetary policy more accommodative.
Third, the Federal Reserve is likely to keep most of these assets on its balance sheet for a long time. As Chairman Bernanke noted in his press conference last week, a strong majority of FOMC participants no longer favor selling agency MBS securities during the monetary policy normalization process. This implies a bigger balance sheet for longer, which provides additional accommodation today and continuing support for mortgage markets going forward.
Fourth, even under this scenario, a rise in short-term rates is very likely to be a long way off. Not only will it likely take considerable time to reach the FOMC’s 6.5 percent unemployment rate threshold, but also the FOMC could wait considerably longer before raising short-term rates. The fact that inflation is coming in well below the FOMC’s 2 percent objective is relevant here. Most FOMC participants currently do not expect short-term rates to begin to rise until 2015.
Got that? If growth disappoints, we'll buy more bonds and for longer. Even if we do slow the pace of bond purchases, we'll still be adding to the total amount of monetary easing in the system, just more slowly. We expect to keep our ginormous balance sheet in place for even longer than it had seemed a week ago, as we now intend not to sell off our mortgage-backed securities portfolio, but rather let it roll off as the bonds mature. And even when we do end our quantitative easing policies, we're not going to hike interest rates anytime soon -- probably not until 2015.
Indeed, it's this last concern, that increases to the short-term rate are near, that Dudley pushes back on most explicitly.
Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC statements and the expectations of most FOMC participants.
We've already heard similar tamping down of the hawkish interpretation of Bernanke's message by Narayana Kocherlakota, the president of the Minneapolis Fed. But Dudley's comments carry extra weight: He is the vice chairman of the policy-setting Federal Open Market Committee, leads the most important of the 12 Federal Reserve banks, and collaborates closely with Bernanke. In other words, he would almost certainly not deliver the message he did Thursday unless he was confident it reflected the consensus of the policy committee.
If there was any doubt, Dudley's speech now seals it: The Fed thinks that markets overreacted to the signals Bernanke sent last week. And markets seem to be getting the message. The Standard & Poor's 500 index was up 0.74 percent at 10:30 a.m., its third straight day of increase, and Treasury bond yields have fallen below 2.5 percent, from 2.61 percent at Tuesday's close.
UPDATE: Another top Fed official spoke a bit later Thursday morning, articulating much the same idea Dudley did. Governor Jerome Powell, speaking at the Bipartisan Policy Center, said that "Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy." He particularly noted, as did Dudley, that market seem to be pricing an interest rate hike sooner than Fed officials envision.