A tribute to Ben Bernanke, sung to the tune of Rudolph the Red-Nosed Reindeer. University of Chicago professor Anil Kashyap unveiled this Friday at economists’ big annual conference.
The Fed believes the stimulus from quantitative easing depends on the stock of Treasuries and mortgage-backed securities that it owns, not on the flow of its purchases. If that view is correct, the future tapering of Fed purchases won’t be monetary tightening, it will a slowing pace of monetary easing (click for larger chart):
The chart shows a hypothetical trajectory for the Fed’s bond and MBS holdings. Under the stock view, that trajectory will go through three stages, paralleling those of traditional interest rate policy:
- Quantitative easing: The Fed expands its balance sheet by buying Treasuries and MBS. Current pace: $85 billion each month.
- Quantitative accommodation: The Fed maintains its balance sheet; it buys new assets to replace older ones as they mature.
- Quantitative tightening: The Fed contracts its balance sheet by allowing assets to mature without replacement or, more aggressively, by selling them.
In this view, tapering is the final stage of quantitative easing. The Fed buys assets during tapering, but at a slower tempo. Tapering is not tightening.
That view is clear, logical, and elegant. But it utterly fails to explain why financial markets went haywire last week when Ben Bernanke and company talked about tapering.
One reason is investor expectations. The Fed has been trying to stimulate the economy not only through QE, but also by telling investors to expect easing in the future. Such forward guidance can be a powerful lever for monetary policy.
Last week, investors learned that QE might end sooner than they expected. In the stock view with expectations, that is monetary tightening. As illustrated in the second chart, future Fed policy would be tighter than financial markets had previously thought.*
This view likely explains some of the market reaction to recent Fed statements. But it’s hard to reconcile the magnitude of the movements. Suppose markets expected tapering to begin in January and now think September more likely. All else equal, that four-month difference implies a $340 billion reduction in the Fed’s ultimate portfolio. That’s something, but could that alone explain the sharp market response?
My sense it that something else must be going on as well. Some candidates include:
- Perhaps the flow of Fed purchases matters, not just the stock. This view appears much more common among traders than Fed economists. If anyone has a reference for a good articulation of this view, I’d love to see it. The flow shouldn’t matter in normal times—was the Fed tightening when the flow of purchases was essentially zero for decades before the recent crisis?—but these are hardly normal times. Perhaps the flow matters when you are at the zero lower bound?
- Perhaps world financial markets expected a much longer period of QE and are highly geared to Fed policy. If I am reading it correctly, that’s the view of Vince Foster who discusses the unwinding of the carry trade (ht Tyler Cowen)
- Perhaps something else also happened. Scott Sumner discusses one possibility: turmoil in China’s financial sector spilling over into U.S. markets.
* This definition of tightening compares the new expected trajectory of Fed holdings to prior expectations. Such comparisons are relative; in principle, one could equally say that the Fed announcement indicated that future policy would be less loose, not that it would be tighter. But for most purposes, it seems simpler just to say that future policy has gotten tighter. The same semantic issue exists in fiscal policy. If Medicare spending is scheduled to grow $35 billion next year, what do we call a proposal under which spending increases $30 billion? We usually call that a $5 billion spending cut since it’s a decline relative to an accepted baseline. But we should remember that Medicare spending is growing. The same seems true with early tapering. Tightening seems the cleanest description for most purposes, even though in absolute terms it is slower easing.
The Business News Network of Canada interviewed me yesterday about TARP and Fed Chairman Bernanke’s “Person of the Year” award from Time Magazine.
Here’s a link to the video of the interview. Going in, I was focused on the following talking points:
- Within current budget rules, the Congress can indeed use unspent TARP money to “pay for” new spending initiatives. However, it needs to cut TARP authority by $2 for every $1 it wants to spend.
- Those “savings” are mythical, however. Treasury Secretary Geithner recently predicted that TARP would use at most $550 billion of its $699 billion in authority. Trimming TARP’s authority by a moderate amount (e.g., $50 billion) will thus generate no actual budget savings. Only deep cuts would begin to generate some savings.
- The financial system is not fully healed, and the United States still lacks a coherent system for dealing with large, failing financial institutions. For that reason, I support Geithner’s extension of TARP as an insurance policy. However, I do not support the TARP extension if its main effect it to allow Congress to use TARP “cuts” to generate mythical budget “savings” or to encourage creative uses of TARP money.
- Usain Bolt had a remarkable year, but Chairman Bernanke is still the right choice as Person of the Year. And he’s the right choice for Fed Chairman.
- But his work is only half done. If he can figure out an exit strategy that keeps the economy growing, avoids new asset bubbles, and sidesteps inflation, then maybe he will be Person of the Year again next year.
David Wessel of the Wall Street Journal reports that President Obama will re-appoint Ben Bernanke as Chairman of the Federal Reserve.
P.S. Don’t let this good news distract you from the much-less-good economic news on Tuesday: CBO and OMB are releasing new budget projections that will show trillions upon trillions of coming deficits.