Wednesday, November 14, 2012

San Fran Fed Head Speaks the Language of Dove, Unrequited

From The Economist's Free Exchange blog:

The end of one big stagnation 
JANET YELLEN is the vice chairman of the Federal Reserve and, I think it's fair to say, the presumptive heir to Ben Bernanke. In a new speech, Ms Yellen provides a nice discussion of the state of monetary policy and explicitly endorses the communications framework advanced by Chicago Fed president Charles Evans and Minneapolis Fed president Narayana Kocherlakota, in which thresholds for key data points like unemployment and inflation are used to provide guidance about the future path of interest rates rather than calendar dates. While Ms Yellen declined to name precise numbers for the thresholds, this is another sign that the Federal Open Market Committee is progressing toward actual adoption of such a framework. As Tim Duy notes, that's an encouraging sign:
Whether the rest of the FOMC follows suit with this approach is another question, but the winds are definitely blowing in that direction. On average then, this is relatively dovish. The Fed is heading toward a policy direction that would explicitly allow for inflation somewhat above target and unemployment below target as long as inflation expectations remained anchored. One would think this should put upward pressure on near term inflation.
One would think, but one would appear to be wrong, as I mentioned yesterday. Mr Duy considers this and grows pessimistic:
Yellen's speech did not even generate a knee-jerk response in the stock market today. I remember a time not long ago when any hint of dovishness was good for a 1% rally. Which...leaves me wondering if open-ended QE is the last of the Fed's monetary tools. We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed's economic objectives are met. Uncertainty about the course of monetary policy has been largely eliminated. There is not likely to be a premature policy reversal. What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment? The Fed could increase the pace of purchases, but would this really change expectations? Can we get more "open-ended?"
I have been thinking along these lines as well. I was initially quite optimistic about the Fed's strategy shift in September, because it appeared to represent a meaningful change in views on the desirability of temporary above-target inflation and because it seemed likely to presage a move toward specific numerical thresholds. And I was heartened by the apparent uptick in economic activity in the early fall. Yet the appearance on the scene of economic headwinds—from Europe, Congress, and elsewhere—has quickly knocked back expectations, just as bad news did before the new policy framework. I thought the new policy would do a better job nailing expectations for faster growth to the floor. I appear to have been mistaken.

The question is why I got it wrong. One possibility is that I didn't, and that I'm just overreacting to a fairly small set of datapoints. Wouldn't be the first time! Another is that my mental model of the recovery is mistaken. Maybe the balance-sheet types are right, and fiscal stimulus is the only thing that can propel a faster recovery and push the American economy off the zero lower bound.

There is another possibility, however, which is that my mental model is mostly right, but I'm underestimating what it takes to reset expectations....MORE
The Free Exchange title is a play on a couple of  papers, follow the link.