As the US economy deteriorated back in 2008, hawkish statements from FOMC members “effectively tightened monetary policy … by pushing up the expected path of the federal funds rate,” explains Richmond Fed economist Robert Hetzel in The Great Recession: Market Failure or Policy Failure. In May 2008, federal funds futures had been predicting the rate to remain at 2% through November. By mid-June, that forecast had risen to 2.5%.
The same type of thing may have just happened with the release of the minutes from the Fed’s January policy meeting. As Reuters explains, “A number of Federal Reserve officials think the central bank may have to slow or stop buying bonds before seeing the pickup in hiring the bold program is designed to deliver.”
To Paul Edelstein, director of financial economics at IHS Global Insight, those opinions may have “inadvertently” produced a tighter monetary policy by altering expectations:
We don’t expect the Fed to curtail or reign in QE3 next month. There are too many voting members who favor continuing bond buying until the labor market outlook improves. And it won’t improve by March.
But the fact that Fed hawks were able to force a debate on the issue makes monetary policy less effective. This is because markets and the public will question the Fed’s commitment to keeping policy in place until it achieves its goals for unemployment and inflation. If markets do not expect the Fed to stay the course, then expectations for economic growth and inflation will stay depressed and demand for safe assets (cash and government securities) will remain high. Counter intuitively, this means lower long-term interest rates, not higher.
Markets will now adjust their growth and inflation expectations downward. Already, the stock market is down 1% (suggesting weaker growth expectations), gold is off 2.6% (suggesting weaker inflation expectations), and the dollar is up about 0.7% (suggesting stronger demand for safe assets). The 10-year Treasury rate shed a few basis points.
There is little that Ben Bernanke can do to quiet the dissenters on his committee. If they feel that QE3 should end this year, they will express those opinions in public and official forums. But what Bernanke and the majority of Fed participants that support ongoing bond buying can do is to more forcefully signal to markets that they will stick with their original plan and stay the course until unemployment comes down. They didn’t do this enough at last month’s Fed meeting, and the minutes portrayed the Doves as leaning on their back foot in the debate.