Wednesday, May 1, 2013
Are The Hawks Screwing Up Bernanke's Signaling?
There is a lot of literature about the conduct of monetary policy at the zero bound, that is, when the policy rate is zero and can’t be lowered. Bernanke is the author of a lot of this literature; it’s one of his academic specialties and why he is uniquely qualified to be chairman at a time when the Fed is operating at the zero bound.
Bernanke has taught us that the monetary authority is not helpless at the zero bound, because the crucial policy tool is not the nominal short-term rate but rather the real short-term rate. The real rate is the nominal rate minus expected inflation. The higher the level of expected inflation, the lower the real rate will be at a zero nominal rate. As an extreme example: If we knew that Bernanke was a madman plotting to destroy the United States via hyperinflation, we would probably want to move our money out of M2 and into something more tangible, like a business or a machine or property. We would know that the real interest rate was about to become highly negative, and thus the cost of holding M2 was about to become very high.
Thus, the policy objective of the Fed today is not to merely increase the monetary base, but rather to make forward statements about the growth of the monetary base that are sufficiently shocking that our inflation expectation will rise. There are many things the Fed could say, such as “we plan to grow the monetary base by one trillion this year and one trillion next year no matter what”. Or they could say “we plan to double the dollar price of gold (or the euro)”. Or they could say, “we will target 5% inflation until unemployment falls below 6.5% on a sustained basis”. But they have said none of those things. They have said almost the opposite.
Remember, the policy objective is to raise inflation expectations in order to make the real funds rate sufficiently negative to change economic behavior; to make liquidity very expensive, and to make risk very cheap; to induce actors to invest in productive capacity instead of M2. Bernanke laid this all out for the Japanese in his inflation speech in Tokyo ten years ago this month.
The simplest measure of inflation expectations is the the long-term risk free rate: the 10-year treasury yield. If the Fed were to succeed in raising inflation expectations, we should expect to see the market demand a higher rate of interest on the 10-year. But the FOMC says that an intended result of QE3 is lower bond yields. I cannot reconcile heightened inflation expectations with lower bond yields.
Today, the FOMC released its monthly statement, and it included the following language:
Longer-term inflation expectations have remained stable.
The Committee anticipates that inflation over the medium term likely will run at or below its 2 percent objective.
These actions should maintain downward pressure on longer-term interest rates.
This exceptionally low range for the federal funds rate will be appropriate at least as long as ...inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
In other words, “we are rapidly expanding our balance sheet, but don’t conclude from this that we wish to lower the real short-term rate”.
I may be missing a crucial element here, but on the face of it I see a glaring problem. And I think I know what the problem is: Bernanke was only able to get the hawks on the FOMC to agree to QE3 on the condition that this silly language be included. Perhaps he even got them to believe it. But if I wanted to raise inflation expectations, I would cross out all of this contradictory nonsense in the next release.
Notwithstanding the foregoing, there is no doubt in my mind that QE3 is bullish for stocks and bearish for bonds if pursued until unemployment comes down to 6.5%. To my mind, a bond sell-off would be a strong signal that QE3 is really working. Once the “conservative” bond investors get clobbered, stocks should benefit from the run out of bond funds.