(Analysis) Chairman Bernanke gave forward-looking guidance of Fed policy last week that left markets in some degree of chaos. By stating that continued quantitative easing (QE) would be contingent on an unemployment rate of 7+%, and revealing optimistic forecasts by the Fed of the unemployment rate, Bernanke was interpreted by markets to mean that “tapering” – reductions to the Fed’s purchases of bonds in pursuit of QE3 – will begin late 2013, and that further QE will end sometime mid-2014.
Two things are possibly going on here. First, markets did not anticipate such strong forward-looking guidance from the chairman. Although Bernanke continued to state that policy would remain driven by data, his tone suggested near assurance that forthcoming data would result in the Fed tapering to zero its further purchases of bonds by mid-2014.
Secondly, Bernanke is likely setting the stage for his successor, with a near-certain transition occurring during the first quarter of next year. The president of the United States recently removed any lingering doubts about Bernanke’s future beyond 2013 at the Fed among many observers. The forthcoming transition is very likely to be an important reason why Bernanke chose to speak the way that he spoke. By revealing a Fed forecast consistent with ending further QE, this allows his successor to stick to this guidance and wind down Fed purchases of bonds (now expectationally neutral), continue purchasing bonds at current amounts (now expectationally more accommodating), or begin selling off Fed-held assets (less accommodating).
Without a pivot to forward-looking guidance strongly suggesting tapering to begin late this year, his successor would be left with fewer (expectational) options, especially on the more accommodating side. This might suggest that Bernanke’s true assessment of economic risks to be on the down side, as his change to the Fed’s forward-looking guidance – no change has been made to actual policy, as bond purchases continue unabated at $85 billion per month – leaves a successor with greater room to maneuver on the accommodative side expectationally. If so, then this is a prudent move on his part, and shows continuing care for the institution that he leads.
So what does this mean to everyday people, you might ask. Well, assuming that the “feral hogs” are kept in check, this leaves the Fed with another (expectational) option should the economy run into trouble. You might think of it as shaping the battlefield – if you are inclined to military metaphors.
NOTE: It is very uncertain how much, if any, the Fed is currently affecting the “real” economy, with nominal interest rates near zero. Both theory and data are inconclusive about this. There is one obvious effect from this policy, however: excess holdings of reserves by depository institutions are skyrocketing. Given current Fed policy to pay 0.25% on excess reserve balances, this amounts to a “soft” bailout of $4.7 billion per year on the excess reserve holdings at the Fed on May 1, 2013. Assuming that banks still remain underwater, QE is one way to repair their balance sheets, or to recapitalize them.