If you want to know what Janet Yellen will do as Fed chair, ignore her congressional testimony and watch Ben Bernanke’s lips.
Yellen, approved Thursday by the Senate Banking Committee, will get the job, but the real action is in speeches by Bernanke, who is less inhibited as he is on the way out, and in the Fed minutes, released Wednesday.
Here is how it is going to go: The Fed will taper, probably early next year, and will try to grease the skids by offering some kind of forward guidance to ease the pain. A bit of fiddling with the interest rate paid by the Fed to banks on reserves is possible too, but a lot less likely.
Forward guidance is fancy central banker talk for making a sort of a promise, or pledge, to keep rates at a particular level in the future if particular conditions prevail. In this case, the forward guidance will probably be to keep rates near zero until unemployment falls below the current trigger level of 6.5%, perhaps as low as 5.5%.
“Even after unemployment drops below 6.5% … the Committee can be patient in seeking assurance that the labour market is sufficiently strong before considering any increase (in the fed funds rate),” Bernanke said in a speech this week.
As for the why, no one is being that specific, but it looks as if Federal Reserve officials are a bit in doubt about bond buying’s efficacy while having some concerns about its attendant risks.
Bond buying, Bernanke said, has “drawbacks not associated with forward rate guidance, including the risk of impairing the functioning of securities markets and the extra complexities for the Fed of operating with a much larger balance sheet.”
The Fed is concerned that its pre-taper communications this summer were incorrectly read, with many investors seeing the move as a tightening in monetary policy. That seems to be behind the idea of pairing a tapering with stronger forward guidance. The Fed hopes it will dull any market effects of the taper, effectively allowing a low-friction way for the central bank to back slowly away from bond buying.
One other possibility is that the Fed will also make adjustments to the interest it pays on reserves, potentially keeping open some facility to allow it to pay less to banks for the money they keep on deposit while not gumming up the vital money market system.
One advantage of this is that it represents an actual action, rather than simply a promise. That said, it is not likely in itself to have a profound effect on bank behaviour.
A few local difficulties
So, tapering with a sweetener, but probably not until March. While Bernanke will hold a press conference after the December FOMC meeting, he may well wish to defer the decision, and the explanation, to his successor.
Yellen will have to live with the program, and as forward guidance is all about effective communication, it makes good sense to allow her to be present and in control when it is paired with tapering.
There are, of course, a few small problems with the whole plan.
The Fed worries that, as when it promised to taper last time, markets will see this as a tightening. They hope forward guidance will work to keep rates low even as they stop buying the bonds. Markets tightened, sending long rates higher, not simply because they didn’t understand the Fed but because they gave precedence to what the Fed was going to do – buy fewer bonds – over what it said it wanted to see.
The point of QE isn’t simply to push people into taking on risk and spending some of their paper gains, it is to make the price of securities with more risk attached rise. The reverse of that implies higher rates for riskier securities, including longer-dated bonds.
Moreover, the whole premise of forward guidance is that central bankers will say something and markets take them at their word. That’s nice in theory, but in practice investors understand that the woman making the promise today is a different one than will be called upon to honour it in a couple of years’ time.
Asked to weigh the value of real dollars going to buy real bonds versus verbal promises about future states none of us can truly know I am betting that markets give primacy to the money, not the pledge.
Tapering may make great sense, but it will not be without friction and costs.
(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.jamessaft@jamessaft.com)