US Monetary Policy: Fed Shifting Focus to Federal Funds Target
US Monetary Policy Communication: Entering a Crucial Period – Historically, the credibility of the Fed ultimately hinged upon the implementation of policy measures aimed at achieving its dual mandate. The twin policy goals were bestowed on the Fed in 1978 when unanticipated inflation was wreaking havoc in financial markets and the real economy. Not surprisingly, in following years, the Fed’s credibility was judged in the context of whether policy measures produced lower inflationary expectations. We now live in different times, where the quality of communication via forward guidance vis-à-vis actual policy measures can determine the perceived credibility of a central bank. The Fed and the Bank of Japan have both flirted with damaging their reputations through mediocre communication with financial markets during 2013. US monetary policy is at a critical juncture with the arrival of a new Fed Chair, along with numerous changes of personnel on the Federal Open Market Committee (FOMC). Throughout 2013, the FOMC has struggled to convince markets that there are two independent pillars to US monetary policy: 1) asset purchases, and 2) short-term interest rate guidance. An early and urgent requirement in 2014 will be for the FOMC to convince markets that these two pillars will continue to remain separate.
Rising Velocity of Circulation of Money: A Risk for US Financial Markets
US Monetary Policy Transmission Mechanism: Set to Change in 2014? One of the salient features of the financial environment since the collapse of Lehman Brothers in 2008 has been the ability of the Fed to boost the money supply (M2) without generating inflation. In fact, the opposite appears to have happened: deflation is a still residual threat to the US economy. The monetary transmission mechanism providing stimulus to the real economy appears to have broken down. There are three sequences that indicate the transmission process is working normally: 1) rising bank reserves boosts the monetary base, 2) broad money supply (M2) starts rising as banks use deposits as managed liabilities to fund lending, and 3) bank credit finally starts increasing. The growth of M2 relative to the monetary base has been far lower in this recovery, indicating a collapse in the so-called money multiplier. Meanwhile, bank credit growth has been particularly erratic, suggesting that things are not quite right with the transmission mechanism. Could things change in 2014?
Closing Out 2013 with Plenty to Think About
Fiscal Gridlock: Light at the End of the Tunnel? The House of Representatives has just passed a budget deal that will, in principle, avert another showdown on fiscal policy for at least two years. The new deal will increase permitted discretionary spending by $48bn over the next two years. This will replace the cuts that would have been imposed by the sequestration process under current law. The increase in discretionary spending is, once again, a triumph for lobbyists. Careful analysis of the deal exposes some shortcomings in terms of supporting aggregate demand in the near-term, mostly notably the failure to extend long-term unemployment benefits.
If passed by the Senate in its current form, the House budget deal will mean that extended unemployment benefits for 1.3 million people will cease on 28 December. The Congressional Budget Office (CBO) estimates that the cost of extending the programme for another two years would be $23bn. Extending the benefits would also have the combined effect of boosting GDP growth by 0.2% and creating 200,000 extra jobs. There is a possibility the Senate may insert another extension of the benefits as part of any compromise agreement.
