Believe those who are seeking the truth. Doubt those who find it. Andre Gide

Wednesday, December 19, 2012

Why El-Erian should be reading Steve Williamson

You have likely heard of Mohamed El-Erian, one of the heads at PIMCO. Let's just say that El-Erian and other major bond investors pay a lot of attention to the conduct of Fed policy and how it's likely to evolve over time.

Here is what El-Erian has to say about the Fed's most recent (Dec 12, 2012) policy statement: How Risky is the Fed's Major Move?
Wow! That is what I suspect many investors said when they heard Wednesday's policy announcement from the Federal Reserve.
The Fed took two major steps on Wednesday, one expected and one less so. 
First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013 -- a very large number by any measure. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance, and it did so earlier than most expected given theoretical and practical complexities.
Maybe a lot of investors, including El-Erian (and myself, for that matter), were surprised by the Fed's move. But I can point to at least one economist who hit the nail right on the head; see, Steve Williamson
First, in terms of the "less surprising" announcement of what was to follow the termination of the MEP, Steve writes:
What you should expect to see is a QE4 program involving purchases of $40 billion in MBS per month and $45 billion in long Treasuries per month.
And what we got:
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 will continue purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month.
Second, in terms of "more surprising" move of replacing the forward guidance language with a state-contingent rule, Steve writes:
This is where the big change in policy is likely to occur. In public statements, various Fed presidents have been honing a policy rule that involves quantitative triggers. ...  
The triggers for liftoff typically take the following form. The policy rate should stay at 0.25% until one of two things happen: (i) the inflation rate rises above x%; (ii) the unemployment rate falls below y%. Most of the public debate currently seems to be over what x and y should be. x is typically in the range 2.5 to 3.0, and y is typically 5.5 to 7.0.
The x in part (i) turned out to be 2.5%, which fell within his predicted range of 2.5-3.0; and the y in part (ii) turned out to be 6.5%, which fell within his predicted range of 5.5-7.0.
Steve didn't quite nail it exactly, however (as he explains in his follow up piece here). In particular, note that the y = 6.5% is not really a "trigger,"--it is just a necessary (but not sufficient) condition for raising the federal funds rate target. What it really means is that the Fed does not plan to "tighten" as long as unemployment remains above 6.5% (and as long as forecast inflation remains below 2.5%). But the Fed may wish to keep the federal funds rate low even if unemployment falls below that threshold. 
(By the way, note that this "trigger" language only applies to the federal funds rate target, not to the Fed's asset purchase programs.)

In any case, I just thought I'd point this out for those people interested in following the Fed: Steve Williamson is your man. Spread the word.


  1. I think it's wrong to characterize 6.5% unemployment as a necessary condition for tightening. They said policy will stay accomodative as long as *three* conditions are satisfied, including unemployment above 6.5% and inflation below 2.5%. That is *more*, not less hawkish than a pure inflation condition. This seems like a good example of the power of the conjunction fallacy.

    1. Yes, they said that they plan to keep the FFR at zero as long as expected inflation is below 2.5% and unemployment above 6.5%. But Bernanke also stressed in his speech that if unemployment drops below 6.5%, that this alone would not trigger tightening. So, I do not think I am wrong in characterizing dropping below 6.5 as a necessary, but not sufficient, condition for tightening.

      Your point is that making the policy one of keeping the FFR at zero as long as inflation remains below 2.5% is more "accommodative" than the current language. I think you are correct. But I do not see how it makes me wrong.

  2. Maybe K meant that unemployment below 6.5% is neither necessary nor sufficient to trigger tightening - in the sense that the Fed has not indicated the intent to keep FFR at zero if unemployment > 6.5% AND inflation forecast > 2.5%. Of course, inflation > 2.5% is neither necessary nor sufficient to trigger tightening using similar logic.

    1. Michael,
      No, I think his point is the following. Consider two separate policy statements, one with the unemployment rate threshold, and one without. Which would have been considered more hawkish? He suggests the the latter. I think he's right.

  3. It seems to me that you see but you do not observe.

    The Federal Reserve is in the business of attempting to restore confidence and manage expectations.

    Anyone who thinks they are not being managed is pretty foolish, although the case has been pretty well recently by Noah that investment bankers and similar types are pretty stupid when it comes to risk.

    Let's be clear about Mr. El-Erian's business. It is a Casino in every attribute save the name over the door. To call him an investor is a serious abuse of the word. Given his interests, I would never pay attention to a word he says, never.

    As an Observer, I could make an overwhelming case that the FED did what it did to support Obama as much as possible on the upcoming Debt Ceiling debate. If the House Republicans screw around, the FED has outlined the price. Fed action until the end of time---as long as the 6.5% goal is open.

    1. Sherlock, did you get into Watson's liquor cabinet again?

    2. No, cocaine.

      I take is straight out of some 120 year old coca cola bottles found in the basement. We are talking Original Coca Cola, not New Coke or New New Coke (corn syrup).

      Bernanke would appear to have a future as a Whip in the House. He is clearly better at counting votes than the Tan Man. And, look at all the people who thought that wasn't part of his job description at the Fed.

      It would be very interesting to find a good political scientist now. We are watching the internal destruction of a political party, which hasn't happened in a long time in the United States. Federalist, Whigs, Democratic Party before the Civil War.

      If Obama was competent, he would finish Tan Man and his followers off by March. All the pieces are now in place. He has the full support of the Fed, so he can take the risk of the Cliff and debt ceiling, short term.

      Some moderate republicans will squeal enough to vote with Nancy sometime before April 1.

      In essence, that is the theme of the current movie, Lincoln. Conflict and stress expose flaws in political institutions, producing the opportunities for greats to appear (Caesar, Washington, Napoleon, Lincoln, FDR, Truman)

      After last night's debacle, my reading of the Fed's actions make a lot more sense than Williamson. Where did Williamson put the Fed's actions in context viz the upcoming House votes?

      It seems to me that most economists need to take off tonight for Vegas and not come back until after the New Year. They will return penniless but will have learned at least the meaning of the word, "bluff."

      I mean, where is it written that the Fed has to tell the truth? And, to the Fed, what is the "truth," anyway?

      It seems to me that these are serious, first order questions, but economists never talk, think, or write about first order questions. For Williamson to pay attention only to what the Fed says and to disregard context is ...

      Taleb/Krugman are right about economists.

      BTW, have you ever asked Williamson, Does Washington University disclose to its undergraduates that if you come here you will never be admitted to a real economics graduate program like Harvard, Princeton, etc. due to Williamson having made everyone ....?

      Have a Merry Christmas. You have a good sense of humor. Use it more, to bring Prosperity to all in the New Year

    3. I spot a crackpot.

  4. Williamson is the signal, Sumner, Beckworth, Thoma (and the crazies who comment on his blog), deLong, Krugman are the noise