Remarks on the Fed

There is lots of discussion on the Fed’s new strategy that could be presented by Ben Bernanke during his press conference. The preferred scenario seems to be one where the US central Bank will reduce its asset purchases to USD 60bn instead of 85. It could be done next September. But nothing will be said on the future path of these purchases. It will be data dependent.

On this decision the most important part will be the reasons of this change. We see that macro data in the USA are not so strong: ISM in the manufacturing sector is at 49, carryover growth for the 2nd quarter is 0 % for industrial production but this is balanced by stronger consumers’ expenditures. The international environment is not so robust either: Mexican industrial production dropped in April (Mexico is very dependent on the US economy) and Chinese data were weak. Bernanke will have to be clear on the reasons if the Fed changes its mind on monetary policy.

Even if there is a change, only purchases will be concerned. Interest rates will remain low for a very long time period (2015?) For this unemployment rate will have to be convincingly below 6.5% and inflation risk remains low. We still have time for that as inflation rate is currently low.
In a little model I use to perceive the Fed’s rate path, a reaction function from the Fed, the interest rate is still negative in May 2013.
In this model there are the fed funds on one side and the spread between core inflation rate and unemployment rate on the other. The estimation period is January 1990 – December 2007. After January 2008 I use the estimated parameters and make a simulation by using the real observed data. It is a model that was developed by Greg Mankiw in 2001 (see here)

In April 2009 the fed funds rate became negative and in May 2013 it is still negative. Due to the non-negativity constraint on interest rates, liquidity injection (QE) was a way to have an accommodative monetary policy.
Negative interest rate in May 2013 means that the US economy does not converge to its previous equilibrium.


This is why there is no urgency to change strategy.

3 points on the possible new strategy

  • Is the US economy strong enough and be able to manage a new monetary policy stance? The improvement seen on real estate and on consumer side is not necessarily independent of what has been done by the Federal Reserve. Will the US economy path be affected? That’s why clear explanations from Bernanke are needed at his press conference.
  • With a new strategy investors will imagine that in a finite time the US central bank will change its mind on interest rates. There will be a premium on long term interest rates, higher than what we currently see.
  • In the last few weeks we’ve seen capital outflows from emerging countries. This is what was said also by the Reserve Bank of India and a reason to keep its interest rates unchanged.
  • Capital flows are very dependent on the US monetary policy. When it becomes accommodative flows go to emerging countries. But when the Fed changes its strategy to become les accommodative flows go back to the USA. If the Fed strategy is confirmed tonight this could accelerate outflows and weaken emerging countries.

There is a last question: we see that the global environment is gloomy. Can we imagine that the Fed could commit to a change in September? The outlook could be better or not? If the Fed’s decision is data dependent can we be sure that Bernanke will announce it tonight?