Friday was a day where a speech by a central banker was eagerly awaited as Ben Bernanke who is Chairman of the US Federal Open Markets Committee gave a speech on monetary policy. However I wish to take us back to one second before he gave the speech and I would contend that he and his colleagues had already made a mistake. This mistake is that everybody feels that they know what his policy is anyway and pretty much everybody expected a relaxation in US monetary policy on the 3rd of November when the FOMC meets next. In effect he has boxed himself in, imagine what would happen on the 4th of November if there was no action from the FOMC? What if economic developments turn out to be a little more favorable? One of the strengths of a central bank is its ability to surprise markets whereas this time round in a reversal of what I consider to be due process markets are driving the FOMC. Indeed the FOMC is facing the fact that it is chasing market expectations rather than driving them.
At a previous speech at Jackson Hole Ben Bernanke said the following.
A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement…………The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible
So one may at first wonder if Ben Bernanke is making what I consider to be a mistake deliberately. He specifically says interest rates in his speech but may have decided to adopt such a policy for all monetary measures. However in the same Jackson Hole speech he said.
A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality.
one disadvantage of asset purchases relative to conventional monetary policy is that we have much less experience in judging the economic effects of this policy instrument, which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.
Although to be fair to football managers even the most incompetent very rarely admit they do not know what they are doing. However the crucial signal in the speech was this sentence.
In particular, the FOMC is prepared to provide additional accommodation if needed to support the economic recovery and to return inflation over time to levels consistent with our mandate.
So additional accommodation is the new euphemism for more quantitative easing or what has been called QE2 and as I will be looking at aircraft carriers later in this article I wish to be clear that whilst both are expensive I feel that the monetary easing will be even more expensive in the long run.
If Mr. Bernanke feels that he has improved the FOMC’s method of communication then, sadly, he has yet another failure on his record. The debate at this time is not one of if but one of how much and on this we were none the wiser when he sat down. As I stated at the beginning of this article this is not a game I feel that central banks should play and now I can add another reason why not, they are simply not very good at it.
The first problem is that the FOMC speaks to a specialist audience and it speaks in a rather esoteric language to them so by the time this arrives at your average person I suspect they neither understand what is happening nor are they much interested. Mr.Bernake might claim that the fact that QE2 is expected is a success for the new policy but this could have been achieved more successfully by simply doing it could it not?
Charles Evans gives us yet another view on FOMC policy
The President of the Chicago Fed. gave a speech a day after Mr. Bernanke which was even more in favour of monetary easing as he gave a speech about price level targeting rather than the inflation level targeting suggested by Mr. Bernanke.
In my opinion, much more policy accommodation is appropriate today……………If you reach the conclusion that we are in a liquidity trap, or even near a perilous liquidity trap, more accommodation is not data-dependent or a close call……..A third and complementary policy tool would be to announce that, given the current liquidity trap conditions, monetary policy would seek to target a path for the price level. Simply stated, a price-level target is a path for the price level that the central bank should strive to hit within a reasonable period of time………..We should put this policy tool on the table and debate its suitability to the current situation in the U.S.
Contrary to what Mr.Evans suggests there are a lot of issues with this type of policy but in terms of establishing his position it would mean that the Fed. would aim to raise the price-level in the United States by some 8/10%. Then his policy would be the same as that of Mr. Bernanke. Or as he puts it.
Inflation would be higher than 2 percent for a time until the path was reattained.
So there you have it and there are a lot of implications from it but Mr. Evans is very sure as he describes such a policy as “nearly optimal”.
This policy of expectations management is not going very well is it? Only one day passed between one view from the Chairman of the FOMC and another more aggressive view from the President of the Chicago Fed. Now whilst Mr. Evans does not have a vote in November I believe that there are some on the FOMC who share his views. So here we have problem number one before you can communicate a policy you have to agree on it! This basic fact appears to have escaped Mr. Bernanke as he gave us policy option 2 at Jackson Hole back in August.
If we return to Mr. Evans’s speech I believe that there are a lot of holes. Regular readers will be aware that in the area of extraordinary monetary measures I believe you should be as clear as to how you will reverse them as you are about implementing them before you start. Here Mr.Evans’s proposal is full of holes.
My response is to continually fall back on the discipline of the state-contingent exit plan. A central bank exercising this policy would have to credibly convey to the public that this policy will end when the price gap is closed.
Only in the “thought-bubble” of a central banker could you say this let alone think it. When the time came to reverse the policy there would be all sorts of other pressures and the FOMC has shown itself to be weak, so Mr. Evans exactly how would you achieve this? Some may already be wondering if he ever intends to do this and to the extent that investors think this then the policy is failing before it has even begun.
Next we get the rather inconvenient fact that inflation figures are subject to revision. What happens if Mr. Evans turns out to have targeted the wrong price level? I wrote on the subject of US inflation indices back on July 2nd and indicated why I feel that its CPI measure is wrong and underscores the level of inflation in the US. We got some weak CPI figures on Friday with annual inflation at 0.8% on an annual basis and the so-called core index at 0.1%. The latest figures for the inflation measure used in Europe and the UK is by contrast at 1.8%. This is a complicated area as Mr. Evans is also looking at the Personal Consumption Expenditure Price Index and I feel that I have introduced quite a few concepts in one day so I will return to it in another update! However I would like to leave in your mind the thought that I have already seen quite a few articles championing proposed moves by the FOMC by people who seem to be unaware that there is some debate about the measurement of US inflation. I would not for example send a rocket to Mars without very careful calculations and being sure about what would happen, however not everybody is the same and I remember the mission from a year or two ago that crashed into it……
Yes Minister turns out to be prescient
I am a fan of the television series and books written on this subject as they were written 20/25 years ago and are as relevant now as they were then. They also manage to be very funny and let’s face it at a time like this a good laugh is beneficial for us all. I was reminded last night of the episode about a hospital which had no patients. Sir Humphrey Appleby who was the representative of the Civil Service advanced the view that it was the most efficient hospital in the UK,hitting all its targets mostly because it had no patients “who only get in the way” of a smooth-running hospital!
What reminded me of this was this from the BBC about the purchase of two new aircraft carriers for the Royal Navy and the emphasis is mine.
Meanwhile, Defence Secretary Liam Fox confirmed the carriers would be left without planes for a period because of cuts to the military budget in the Spending Review.
Perhaps they will be the most efficient carriers in the world without airplanes messing up their smooth operation….