Jeremy C Stein: Comments on monetary policy
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the C. Peter McColough Series on International Economics, Council on Foreign
Relations, New York City, 28 June 2013.
* * *
Thank you very much. It's a pleasure for me to be here at the Council on Foreign Relations,
and I look forward to our conversation. To get things going, I thought I would start with some
brief remarks on the current state of play in monetary policy. As you know, at the Federal
Open Market Committee (FOMC) meeting last week, we opted to keep our asset purchase
program running at the rate of $85 billion per month. But there has been much discussion
about recent changes in our communication, both in the formal FOMC statement, as well as
in Chairman Bernanke's post-meeting press conference. I'd like to offer my take on these
changes, as well as my thoughts on where we might go from here. But before doing so, let
me note that I am speaking for myself, and that my views are not necessarily shared by my
colleagues on the FOMC.
It's useful to start by discussing the initial design and conception of this round of asset
purchases. Two features of the program are noteworthy. The first is its flow-based,
statecontingent nature - the notion that we intend to continue with purchases until the outlook for
the labor market has improved substantially in a context of price stability. The second is the
fact that - in contrast to our forward guidance for the federal funds rate - we chose at the
outset of the program not to articulate what "substantial improvement" means with a specific
numerical threshold. So while the program is meant to be data-dependent, we did not spell
out the nature of this data-dependence in a formulaic way.
To be clear, I think that this choice made a lot of sense, particularly at the outset of the
program. Back in September it would have been hard to predict how long it might take to
reach any fixed labor market milestone, and hence how large a balance sheet we would
have accumulated along the way to that milestone. Given the uncertainty regarding the costs
of an expanding balance sheet, it seemed prudent to preserve some flexibility. Of course, the
flip side of this flexibility is that it entailed providing less- concrete information to market
participants about our reaction function for asset purchases.
Where do we stand now, nine months into the program? With respect to the economic
fundamentals, both the current state of the labor market, as well as the outlook, have
improved since September 2012. Back then, the unemployment rate was 8.1percent and
nonfarm payrolls were reported to have increased at a monthly rate of 97,000 over the prior
six months; today, those figures are 7.6 percent and 194,000, respectively. Back then,
FOMC participants were forecasting unemployment rates around 7-3/4 percent and
7 percent for year-end 2013 and 2014, respectively, in our Summary of Economic
Projections; as of the June 2013 round, these forecasts have been revised down roughly
1⁄2 percentage point each. While it is difficult to determine precisely, I believe that our asset
purchases since September have supported this improvement. For example, some of the
brightest spots in recent months have been sectors that traditionally respond to monetary
accommodation, such as housing and autos. Although asset purchases also bring with them
various costs and risks - and I have been particularly concerned about risks relating to
financial stability - thus far I would judge that they have passed the cost-benefit test.
However, this very progress has brought communications challenges to the fore, since the
further down the road we get, the more information the market demands about the conditions
that would lead us to reduce and eventually end our purchases. This imperative for clarity
provides the backdrop against which our current messaging should be interpreted. In
particular, I view Chairman Bernanke's remarks at his press conference - in which he
suggested that if the economy progresses generally as we anticipate then the asset
purchase program might be expected to wrap up when unemployment falls to the 7 percent
range - as an effort to put more specificity around the heretofore less well-defined notion of
"substantial progress."
It is important to stress that this added clarity is not a statement of unconditional optimism,
nor does it represent a departure from the basic data-dependent philosophy of the asset
purchase program. Rather, it involves a subtler change in how data-dependence is
implemented - a greater willingness to spell out what the Committee is looking for, as
opposed to a "we'll know it when we see it" approach. As time passes and we make progress
toward our objectives, the balance of the tradeoff between flexibility and specificity in
articulating these objectives shifts. It would have been difficult for the Committee to put
forward a 7 percent unemployment goal when the current program started and
unemployment was 8.1 percent; this would have involved a lot of uncertainty about the
magnitude of asset purchases required to reach this goal. However, as we get closer to our
goals, the balance sheet uncertainty becomes more manageable - at the same time that the
market's demand for specificity goes up.
In addition to guidance about the ultimate completion of the program, market participants are
also eager to know about the conditions that will govern interim adjustments to the pace of
purchases. Here too, it makes sense for decisions to be data-dependent. However, a key
point is that as we approach an FOMC meeting where an adjustment decision looms, it is
appropriate to give relatively heavy weight to the accumulated stock of progress toward our
labor market objective and to not be excessively sensitive to the sort of near-term momentum
captured by, for example, the last payroll number that comes in just before the meeting.
In part, this principle just reflects sound statistical inference - one doesn't want to put too
much weight on one or two noisy observations. But there is more to it than that. Not only do
FOMC actions shape market expectations, but the converse is true as well: Market
expectations influence FOMC actions. It is difficult for the Committee to take an action at any
meeting that is wholly unanticipated because we don't want to create undue market volatility.
However, when there is a two-way feedback between financial conditions and FOMC
actions, an initial perception that noisy recent data play a central role in the policy process
can become somewhat self-fulfilling and can itself be the cause of extraneous volatility in
asset prices.
Thus both in an effort to make reliable judgments about the state of the economy, as well as
to reduce the possibility of an undesirable feedback loop, the best approach is for the
Committee to be clear that in making a decision in, say, September, it will give primary
weight to the large stock of news that has accumulated since the inception of the program
and will not be unduly influenced by whatever data releases arrive in the few weeks before
the meeting - as salient as these releases may appear to be to market participants. I should
emphasize that this would not mean abandoning the premise that the program as a whole
should be both data-dependent and forward looking. Even if a data release from early
September does not exert a strong influence on the decision to make an adjustment at the
September meeting, that release will remain relevant for future decisions. If the news is bad,
and it is confirmed by further bad news in October and November, this would suggest that
the 7 percent unemployment goal is likely to be further away, and the remainder of the
program would be extended accordingly.
In sum, I believe that effective communication for us at this stage involves the following key
principles: (1) reaffirming the data-dependence of the asset purchase program, (2) giving
more clarity on the type of data that will determine the endpoint of the program, as the
Chairman did in his discussion of the unemployment goal, and (3) basing interim adjustments
to the pace of purchases at any meeting primarily on the accumulated progress toward our
goals and not overemphasizing the most recent momentum in the data.
I have been focusing thus far on our efforts to enhance communications about asset
purchases. With respect to our guidance on the path of the federal funds rate, we have had
explicit links to economic outcomes since last December, and we reaffirmed this guidance at
our most recent meeting. Specifically, we continue to have a 6.5 percent unemployment
threshold for beginning to consider a first increase in the federal funds rate. As we have
emphasized, the threshold nature of this forward guidance embodies further flexibility to react
to incoming data. If, for example, inflation readings continue to be on the soft side, we will
have greater scope for keeping the funds rate at its effective lower bound even beyond the
point when unemployment drops below 6.5 percent.
Of course, there are limits to how much even good communication can do to limit market
volatility, especially at times like these. At best, we can help market participants to
understand how we will make decisions about the policy fundamentals that the FOMC
controls - the path of future short-term policy rates and the total stock of long-term securities
that we ultimately plan to accumulate via our asset purchases. Yet as research has
repeatedly demonstrated, these sorts of fundamentals only explain a small part of the
variation in the prices of assets such as equities, long-term Treasury securities, and
corporate bonds. The bulk of the variation comes from what finance academics call "changes
in discount rates," which is a fancy way of saying the non-fundamental stuff that we don't
understand very well - and which can include changes in either investor sentiment or risk
aversion, price movements due to forced selling by either levered investors or convexity
hedgers, and a variety of other effects that fall under the broad heading of internal market
dynamics.
This observation reminds us that it often doesn't make sense to try to explain a large
movement in asset prices by looking for a correspondingly large change in expectations
about economic fundamentals. So while we have seen very significant increases in long-term
Treasury yields since the FOMC meeting, I think it is a mistake to infer from these
movements that there must have been an equivalently big change in monetary policy
fundamentals. Nothing we have said suggests a change in our reaction function for the path
of the short-term policy rate, and my sense is that our sharpened guidance on the duration of
the asset purchase program also leaves us close to where market expectations - as
expressed, for example, in various surveys that we monitor - were beforehand.
I don't in any way mean to say that the large market movements that we have seen in the
past couple of weeks are inconsequential or can be dismissed as mere noise. To the
contrary, they potentially have much to teach us about the dynamics of financial markets and
how these dynamics are influenced by changes in our communications strategy. My only
point is that consumers and businesses who look to asset prices for clues about the future
stance of monetary policy should take care not to over-interpret these movements. We have
attempted in recent weeks to provide more clarity about the nature of our policy reaction
function, but I view the fundamentals of our underlying policy stance as broadly unchanged.
Thank you. I look forward to your questions.