The Federal Reserve made a major and dramatic change to their monetary policy today, moving forward with a third round of quantitative easing that is actually more modest than the first two. However, the much more crucial component to the policy action was the open-ended nature of the commitment, including a promise to keep interest rates low even after the recovery takes hold.
Here’s the statement from the Federal Open Market Committee, and this is the key section:
To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.
The Fed doubled this up by extending the target date for the near-zero federal funds rate to mid-2015. And it added, “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
This is the most important part of the announcement. The monthly asset purchases of $40 billion (the $85 billion comes in the context of the conclusion of “Operation Twist,” the program to increase the maturities of its holdings) are actually smaller than in QE1 or QE2; about 50% smaller, to be exact. Since the jury’s out on whether the first two rounds even worked, that would seem to suggest problems for QE3. But the crucial element is the open-ended commitment. In a highly regarded paper given a couple weeks ago, monetary theorist Michael Woodford suggested that the Fed merely purchasing assets would not actually stimulate the economy. They needed to add a communications component that suggested an ongoing commitment. As Paul Krugman explained:
Woodford parses the evidence, and concludes tentatively that most of the apparent effects of QE actually come through the expectations channel — that is, that QE works, to the extent it does, largely because markets see it as a form of forward guidance.
So what should the Fed be doing? Woodford concludes that it needs to make a change in its basic policy pronouncements, so as to make them “history-dependent” — that is, it needs to promulgate a view of its intentions that would lead it to be slower to raise rates following a big slump than it would in other circumstances. And let me repeat the past tense: following a big slump, not just when you’re in it.
That’s essentially what the Fed has done. By saying that they would not raise rates until after a recovery, they are signaling that they would allow for higher inflation and not tighten monetary policy in reaction. This allows for “catch-up” growth and would be the policy you would undertake if you targeted nominal GDP, unadjusted for inflation.
More impressive is that only one member of the Federal Open Market Committee, Jeffrey Lacker of the Richmond Fed, opposed the action. This means that virtually all the monetary policymakers believe in this course of action.
It’s certainly warranted. While some economic indicators show stronger growth ahead, mass unemployment remains a serious problem, one that does not look to be improving. The intention to continue with monetary accommodation will hopefully be enough to pull money into the economy and stimulate growth. We will see Woodford’s theories put to the test.
This is generally good news for the economy.
UPDATE: Chuck Schumer responds: “The Fed is fulfilling its obligation to take action to address unemployment. Now congressional Republicans need to fulfill theirs.”