Wednesday, January 7, 2009

FOMC minutes show the Fed is trying to think outside the box

Now that I have read the minutes of the December 15-16 Federal Open Market Committee (FOMC) meeting, I see this: the Fed is worried, and illustrated through its use of the term excess reserves, that current policy-to-date is not enough. It needs to think outside the box.

I found the FOMC’s use of the term excess reserves on 10 separate occasions interesting. It highlights the Committees focus on what it has done already, increased the balance sheet $1.35 trillion to $2.25 trillion in one year via alternative liquidity measures, and what it is planning going forward: “use of FOMC communication with the public to provide more information regarding future policy intentions.” If communication is the best that the Committee can come up with, then the ongoing market angst is well deserved because the Fed's communication skills have been rather poor.

To be sure, the "communication" is in reference to a explicit inflation target, but that is certainly not thinking outside the box.

EXCESS RESERVES in the Minutes

"With the federal funds rate already trading at very low levels as a result of the large volume of excess reserves associated with the Federal Reserve's liquidity operations, participants agreed that the Committee would need to focus on other tools to impart additional monetary stimulus to the economy in the near term."

RW: And the rest of the paragraph goes on to talk about the Fed’s need for added communication regarding its policy objectives – even entertaining an inflation target. Although the Fed probably should indicate its policy objectives promoting some inflation (fighting the deflationary tendencies), it is unlikely to change its official policy in the middle of a banking crisis.

"as economic activity recovered and financial conditions normalized, the use of certain policy tools would need to be scaled back, the size of the balance sheet and level of excess reserves would need to be reduced, and the Committee's policy framework would return to focus on the level of the federal funds rate."

RW: This policy is not permanent...

"under the approach of conducting monetary policy by acquiring a variety of assets as needed to address financial and macroeconomic strains, the quantity of excess reserves and the size of the Federal Reserve's balance sheet would be determined by the Federal Reserve's asset purchases and the usage of its lending facilities. It was likely that, during the period of financial turmoil, the size of the Federal Reserve's balance sheet would need to be maintained at a high level."

RW: ... but it will continue in the near term. The Fed will continue its elevated lending facilities, making no mention of an official target, or objective.

"Several other participants, however, noted that increases in excess reserves or the monetary base, by themselves, might not have a significant stimulative effect on the economy or prices because the normal bank intermediation mechanism appeared to be impaired, and banks may not be willing to lend their excess reserves."

RW: The FOMC understands that current monetary policy is not able to stimulate the macroeconomy since the credit crisis is stopping up the lending of the monetary base (excess reserves). Monetary policy is now geared toward the health of the credit markets.

"Conversely, a decline in excess reserves or the monetary base would not necessarily be contractionary if it occurred in the context of improving financial market conditions."

RW: As financial markets improve, the cork that is stopping up bank lending will pop out. The money supply will be able to stand on its own without the Federal Reserve’s cane of excess reserves.

"Committee members recognized that the large volume of excess reserves had already resulted in federal funds rates significantly below the target federal funds rate and the interest rate on excess reserves"

RW: The committee cannot not have it all: maintain a target interest rate and add excess reserves in large quantities.

"Since the large amount of excess reserves in the system would limit the Federal Reserve's control over the federal funds rate, several members thought that it might be preferable not to set a specific target for the federal funds rate."

RW: They decided to drop the target, and focus on reserves and lending.

"However, other members noted that not announcing a target might confuse market participants and lead investors to believe that the Federal Reserve was unable to control the federal funds rate when it could, in fact, still influence the effective federal funds rate through adjustments of the interest rate on excess reserves and the primary credit rate."

RW: The Fed still thinks that it can control (at least partially) the effective federal funds rate through the manipulation of substitute interest rates. The only direction that the FOMC could target the effective funds rate is up, since at the time the effective federal funds rate was trading at 0.18% (pretty close to zero). And I simply do not see how it could do that with $800 billion in excess reserve balances.

RW: There you have it – excess reserves 10 times - the Fed has tried growing its balance sheet through various lending programs that have resulted in a ballooning of excess reserves. What next? The FOMC revised downward its forecast:

All told, real GDP was expected to fall much more sharply in the first half of 2009 than previously anticipated, before slowly recovering over the remainder of the year as the stimulus from monetary and assumed fiscal policy actions gained traction and the turmoil in the financial system began to recede. Real GDP was projected to decline for 2009 as a whole and to rise at a pace slightly above the rate of potential growth in 2010. Amid the weaker outlook for economic activity over the next year, the unemployment rate was likely to rise significantly into 2010, to a level higher than projected at the time of the October 28-29 FOMC meeting (the forecast peaked at 7.6% in 2009). The disinflationary effects of increased slack in resource utilization, diminished pressures from energy and materials prices, declines in import prices, and further moderate reductions in inflation expectations caused the staff to reduce its forecast for both core and overall PCE inflation. Core inflation was projected to slow considerably in 2009 and then to edge down further in 2010.
The Fed is battling a formidable opponent; one that is has fought on just a few occasions. It is not a surprise that the Fed must rewrite policy, as standard policy is impotent during a financial crisis. But it is obvious that the Fed needs fresh ideas since its efforts-to-date have only dented the wall of financial market uncertainty.

Rebecca Wilder


Janie said...

And the Fed has now pushed projected fall of real GDP out through 2009. Isn't that farther (by 6 months) than has been stated before? Thanks for their statements and the explanatory comments, Rebecca! "Verrry interesting..." as someone we all knew and loved used to say.

Irrational Doomsday Blog said...

I wonder how much of this mess was enhanced by panic induced by the Fed.

A surprise, ultimatum-laid trip to Congress for the TARP. Unprecedented move after unprecedented move in pledges and guarantees. Even the language of their releases is moving a great deal from the normally supremely muted, almost doublespeak that you usually hear from them.

Honestly all I hear from them is "we don't know what to do, but we're going to do a lot of it."

David Pearson said...


I think the Fed is still "in the box". The gist of the minutes is that the Fed is trying to support real growth by propping up the credit markets. This is "asset side" targeting, and the Fed's essentially been using it since September '08 (if not before, dating back to the TAF inception).

There's four levels to Quantitative Easing, each implying a risk to the Fed's credibility: 1) asset side targeting; 2) quantitative target; 3) inflation target; 4) price level target.

The minutes confirm that the Fed is still stuck in the first level. While they are scared of deflation, they are apparently not THAT scared.

Flow5 said...

Which side of the FED's balance sheet it is changing is completely irrelevant.

The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves

James said...

I think it's odd that excess balances began increasing the first week of September. That was right after the Republican National Convention failed to produce the desired post-convention bounce in the polls. There was one, but it was just delayed. It occurred after excess reserve balances began increasing.