When the Generals Talk

The last two days have seen Fed Chairman Bernanke and NY Fed head Dudley speak, with markets ultimately taking a hawkish view of comments that the rate of asset purchases could be scaled back in the next few meetings.  The fact the Chairman has mentioned this suggests the prospect of tapering is more than the wish of a couple of consistent hawks in the FOMC.

But ultimately the bet for markets comes down to what they think about the data in coming months rather than how they parse the comments from FOMC members. While payrolls will be everyone's focus, weak inflation outcomes should be a key consideration.

The key variable which seems to be contributing to wavering support for the current rate of QE is the improvement in the labour market and it seems market expectations on the next Fed move will be highly contingent on the next few payrolls releases.  As I wrote about here, there is still quite a bit of slack in labour markets when accounting for the drop in the participation rate, which was alluded to by one FOMC member in the minutes.

It's worth pointing out that FOMC forecasts are for a fairly uniform improvement in the unemployment rate from here. But previous experiences suggest that better labour market outcomes should generate higher participation (particularly in the 25-54 age category, which has dropped ~2ppt in the last few years).  Remember in the 1980s, the unemployment rate dropped quickly to 7.5%, but took almost 3 years after this to get to 7%.

Let's also not forget the other central part of the mandate in price stability.  Both Bernanke and Dudley spoke about the importance of anchoring medium term inflation expectations as a powerful policy tool when policy rates are constrained by the zero lower bound. These have been anchored solidly around 2% for sometime, although have edged lower more recently.

But let's not forget about actual inflation incomes in the near term, which are uncomfortably low.  This is probably more important as the Fed has a defined target for inflation, but its wording around maximum employment is decidedly ropey.

While Dudley's speech didn't move markets as much as the Chairman, it contained some very interesting insight into his thinking on policy and the way forward, with his way of thinking not dissimilar to other key members of the FOMC.

The first key point was that Dudley believes that the original framwork provided in 2011 for winding down of QE is now stale given the composition of the balance sheet has changed and so have thresholds for changing tack on policy.  This is particularly important for MBS markets, with Dudley commenting that the original framework may not make sense in the context of keeping this market stable now that the Fed holds a lot more mortgage-backed bonds.

The other point was more general and in regards to the balance of risks.  Dudley admitted that the FOMC forecasts had been too optimistic over the past few years and ultimately they should have done more than they did rather than less. As shown on the chart left, the FOMC has been mostly revising GDP downwards for the last couple of years.

Comparing this with the Japanese situation, Dudley remarked "Perhaps, if we had paid more attention to the persistent divergence between growth forecasts and outturns in Japan in the 1990s, we might have been more skeptical about the prospects for a strong economic recovery, even with a more aggressive monetary policy regime."

This view is bereft of knowledge of the longer-term consequences of QE, but this mindset is certainly going to play a role when considering the next move from the Fed.  For Bernanke, this may be even more important to keep in mind, given his tenure at the Fed ends at the end of this year.