Quick Notes On Fed Policy

By Karl Smith

As I mentioned last year, the message is the policy, and looser Fed policy would like follow the following path

Why is this important. Because the difference between extended period and mid-2013 highlights the significance of the Fed wording. Had this simply meant “so long as appropriate” there really wouldn’t be a difference between extended period and 2013.

This statrment is rightfully viewed as a quasi-commitment by the Fed to keep interest rates at zero for two more years.

What you would want to see is the phrase “at least through mid-2013” repeated over and over in new statements and speeches. That will solidify the commitment.

Remember that the last thing you want to do as a central banker is hurt your credibility. So, repeating specific dates indicates that those dates have real meaning.

If the Fed were to begin to tighten its stance the first thing you would expect to see is the phrase “at least” removed from statements and speeches. Further tightening would move us to something phrasing like “possibly through mid-2013”

How the Fed frames the certainty of its statements tells you how tight the policy is.

Now we have moved to...

...are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014

What is important here is that this is a loosening of policy. It is not a promise to be loose. It IS loosening.

Why?

Because, what matters to bankers is the entire path of the Fed Funds rate from now into the future.

Suppose, that a developer wants to build a new apartment complex – highly relevant in our current environment.

The first thing you do is get a construction loan. This will last about 18 months or so and will be interest only. It also comes out in draws and there some other issues only tagentally relevant to us.

Part of what the Fed is saying here is: for the length of the construction loan we expect the bank to be able to raise funds at zero cost. That’s nice and it lets me as a banker know that there are going to be no rate shocks during this project.

Now, at the end of that 18 months the apartment developer is going to have to get a new loan. Then use those proceeds to pay me in full. A very important consideration for me is whether or not I think she will be able to get that loan.

The Fed is saying look, one of two things will happen. Either the economy will be growing much steadier or interest rates are still going to be zero. Well in either of those cases my developer has a good chance of rolling her loan.

This means that it is a pretty safe bet for me to go ahead and fund this construction loan today.

So anticipation of what is going to happen tomorrow walks back to the present in a very straight forward way. Its not a complex or esoteric expectations problem. As a banker I need to know what is going to happen to my loan and the Fed is helping me figure that out.

On the more esoteric end of things. The Fed also said

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

Now some people might be saying big freaking news. Well maybe not big freaking but not trivial. First of all PCE aint CPI.

As you can core CPI has already broken through 2% year-over-year. On the other hand core PCE has stalled below 2%

The difference between the two is that CPI is attempts to measure what consumers buy or quasi-bought in the case of owner’s equivalent rent. PCE measures all the stuff that is not investment and not direct expenditure by the government.

I’ve noted before that Core CPI and housing costs are basically two different phrases for the same thing. This is less true with CPE, and with housing costs on the rise one can expect core CPI and core PCE to run at different rates.

Next

If you look back at the minutes of previous meetings you say some folks tossing around numbers like 1.25% PCE price index growth as the right target. Basically, those numbers have been overruled, so this is looser than the past Fed.

Last and more weedsy

There is some evidence that a point target is interpreted by financial markets as more flexible than a range. So, if the Fed were to say we want Core PCE somewhere between 1.5% and 2.5% that would actually be thought of as stricter than saying we want Core PCE at 2%.

The reason is that with the range people start saying stuff like “inflation has broken through the Fed’s comfort zone!” and expect immediate tightening. However, with a point target they will say “We have been drifting above 2% for a while and so we expect the Fed will want to bring us back down eventually”

I should have more to say later but that is an off the cuff response. This is looser monetary policy.

Oh, and I will just note that my viceral response to “late 2014” was “mmmhhh” which means that we are moving from “why aren’t we hitting the gas, go, go, go” to “Well, lets talk about this. Late 2014 you say. Do we have an early exit strategy. I wouldn’t mind reviewing. Just in case you know.”