Taper tantrum

Talking about Tapering

In May, we argued that the FOMC needed to communicate its contingency plans for what they would do should the recent inflation pickup prove more stubborn than its members expect. Such transparency makes it more likely that financial markets will respond to incoming data rather than to policymakers’ actions. By clearly laying out their reaction function, central bankers can avoid disruptions like market taper tantrums.

In June, the FOMC began to remove the self-imposed communication shackles designed to encourage “lower for longer” interest rate expectations and address inflation risks more openly. Indeed, as the above citation from Chairman Powell indicates, at their June meeting, policymakers began to lay the groundwork for scaling back their large-scale asset purchases (LSAPs).

In this post, we start by highlighting how recent Fed communication (which reveals appropriate humility about inflation projections) has helped avoid a market tantrum so far. Along the way, we discuss the various means that FOMC participants have used to express their changing views about the timing of interest rate increases (“liftoff”), even as they make clear that tapering their asset purchases will come first….

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Stopping central banks from being prisoners of financial markets

Central banks are on the front lines in the fight to limit the impact of the pandemic. They are supporting virtually every aspect of the economy and the financial system. Combined with the massive fiscal support, these policies restored market stability, safeguarded financial institutions, and reduced suffering. Count us among those who firmly believe that everyone would be in worse shape had central banks and fiscal authorities not coordinated this aid as they did.

But, by providing such a broad backstop, the reliance of financial markets on that support can itself become a source of instability. This raises a set of very important and pressing questions: Have central banks’ actions over the past year made financial markets their masters? Can policymakers now be counted on to suppress financial volatility wherever it arises?

We surely hope not, but we see this as a legitimate concern. Fortunately, we also see a solution. Central bankers should strive to duplicate the success of their framework for interest rate policy. That is, they should be clear and transparent about their reaction function for all their policy tools. Knowing how policy will react, markets will respond directly to news regarding economic conditions, and less to policymakers’ commentary. Of course, central bankers cannot ignore shocks that threaten economic and price stability. But cushioning the economy against large financial disturbances does not mean minimizing market volatility….

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Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact.... 

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