Everything that needs to be said has already been said.
But since no one was listening, everything must be said again.

Andre Gide

Wednesday, November 3, 2010

What is Clear and Not so Clear About Fed Policy (Part 2)

Today's FOMC statement is available here: FOMC November 03, 2010. Thought it might be a good time to follow up on my earlier (September 23) post: What is Clear and Not so Clear About Fed Policy.

On September 23, I said the following (let me summarize):

What was clear: The Fed will stand ready to do "whatever it takes" to make sure inflation expectations remain anchored at around 2% per annum. With inflation still on the low side of this target and the labor market still weak, it is not surprising that the Fed today a program to expand the size of its balance sheet.

What was not so clear: The Fed was not clear on the tactics it meant to employ to anchor long-term inflation expectations. I suggested that a good bet would be a program designed to purchase longer-dated treasuries, with purchases following a state-contingent rule (depending on how economic events turned out). This is what we got:
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
Well, looks like I was half right. What surprised me here were the stipulated size and time limits; i.e., $600B figure by 2011:Q2. Why $600B and not $500B or $700B? No idea. Why 2011:Q2 and not 2011:Q1 or 2011:Q3? No idea.

The coexistence of the "state-contingent" and "size/time limit" language in the statement above may reflect a possible compromise between groups arguing for one or the other. But the "size/time limit" language seems somewhat redundant in my view; at least, given that we believe that the Fed is commited to 2% inflation. For example, what happens at the end of 2011:Q2 if inflation is still running at 1% with unemployment near double digits? Answer: a likely repeat, going further out along the yield curve, if necessary. But this is likely to happen (under the hypothesized contingency) whether or not these size/time limits were in place to begin with.

Finally, what was downright blurry in my previous post continues to remain hazy, in my view.


  1. David,

    What's the measure of inflation that the Fed uses?

    Also, are open market operations basically still conducted as they were in the 1990s, by purchasing/selling Treasury securities from a small group of banks?

  2. Prof J:

    It is my understanding that the Fed is legally prohibited from purchasing debt directly from the Treasury; it is done via primary dealers.

    I think the Fed looks at a variety of inflation measures, including CPI and core CPI. The Fed also monitors short and long term inflation expectations as reported, say, by the Survey of Professional forecasters.

  3. David,

    Thanks. I'm fleshing out a research paper (corporate finance) that is related to how (operationally) the Fed expands money supply.

    The papers I've been reading (Friedman and Kuttner have a nice review) seem to indicate that the target FF rate is effectuated through announcement effects rather than genuine reserve supply increases/decreases (liquidity effect). Any thoughts?

    Also, Meltzer has an op/ed in today's WSJ where we speculates that the Fed went to the PCE in the 1990s and has recently gone back to CPI because currently CPI will understate inflation relative to PCE.

  4. Prof J: We have a number of experts here at the Fed that can help you out. Email me, if you are interested in visiting us.

    I have not read Melter's piece. I am skeptical of his argument, but who knows...