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Last week, we sent out an email
arguing that if the ECB’s reaction function had changed in recent
years in the same way that the Bank of England’s has, it would have
purchased around €2.2tn of assets (What if the ECB’s
reaction function started to look like those elsewhere?
– March 1, 2013). The
motivation for the email was to give a sense of what doing
“whatever it takes” might look like, even without the ECB’s
reaction function shifting any more than what has already happened
at the Bank of England.
Not surprisingly, we
have been asked how this analysis applies to the Fed. Before doing
this exercise, it is worth highlighting that the Fed may not share
the perspective of this approach. In particular, the Fed’s
assessment of the impact of large scale asset purchases may be very
different to the Bank of England’s. The judgment of how to convert
large scale asset purchases into policy rate space is critical for
determining exactly how reaction functions are changing. The less
impact that asset purchases have on growth and inflation, the less
of a shift in the shape of the reaction function relative to before
the crisis. Moreover, the Fed may have a different view about the
coefficients in the Taylor rule, with more weight placed on the
output gap term than in John Taylor’s original
specification.
Moreover, it should be
stressed that the biggest shift in the Fed’s reaction function is
not in the present, but rather in the future. Through forward
commitments, now numerical thresholds, the Fed is committing to
keep policy unchanged even as the macro landscape evolves in a way
that normally would be expected to prompt tighter policy. Indeed,
to the extent that the Fed does not think that asset purchases have
as large an impact as we described in the original email, the
forward commitments on rates can be viewed as a device to
compensate for the inability to add more stimulus in the
present.
Given these caveats, it
is still worth going through the exercise to reinforce the point of
the original email. Essentially, that the ECB could do a lot more –
along the lines of “whatever it takes” - and the change in its
reaction function would not be any greater than what has already
occurred elsewhere.
But, before we look at
forward commitments, let’s apply the analysis of the original email
to the present situation in the US. With an output gap of -5.7%
(the latest CBO estimate) and the core PCE deflator at 1.3%oya, the
standard Taylor rule - with a coefficient on the output gap term of
0.5 and a coefficient on the gap between inflation and the long run
inflation objective of 1.5 - would suggest that the appropriate
policy rate in the US is currently zero. If we convert the balance
sheet into policy rate space using the Bank of England’s
methodology, the actual policy rate is -2.4%. To get the
appropriate policy rate to be -2.4%, the coefficient on the output
gap term in the Taylor rule would need to be increased from 0.5 to
1.0. This looks much more modest than the shift at the Bank of
England where we argued that the coefficient on the output gap term
has increased from 0.5 to 2.0.
The argument that the
forward commitments on rates can be viewed as a device to
compensate for the inability to add more stimulus in the present
can be illustrated by assuming that the Taylor rule should have a
coefficient of 1.0 on the output gap term, rather than the 0.5 in
the original specification, and that asset purchases have a much
smaller impact than the Bank of England’s calculations would
suggest. With a coefficient of 1.0, the appropriate policy rate
would be -2.75%. If the Fed believes that the impact of large scale
asset purchases is significantly less than the Bank of England’s
estimate, then it may not be possible to achieve an effective
policy rate that low. Thus, the forward commitments can be viewed
as an attempt to offset this constraint.
Thus, the real shift in
the Fed’s reaction function is more about communication about the
future rather than the stance in the present. We can illustrate
this by looking at the Fed’s projections for late 2015, when the
Fed expects the unemployment rate to have moved below the 6.5%
threshold and core PCE inflation to be around 2% (in line with the
central bank’s long run objective). Given that the Fed also tells
us that it thinks the natural rate of unemployment is between 5%
and 6%, we can use all this information in a standard Taylor rule
to get a prediction of the appropriate policy rate. The standard
Taylor rule would suggest an appropriate policy rate in late 2015
of 3.25%.
So where will the
actual policy rate be in late 2015? The Fed has told us that the
funds rate target will still be 12.5bp and it seems reasonable to
assume that by then large scale asset purchases will have amounted
to around $3.3tn. The current pace of purchases ($85bn per month)
will continue for a while and when they stop the balance sheet will
be maintained at that size until at least late 2015. If we use the
Bank of England’s methodology to convert these asset purchases into
policy rate space, then the actual policy rate is -3% (the Fed
funds target of 0.125% minus the balance sheet effect worth
-3.16%).
There is thus a huge
gap between what a standard Taylor rule would suggest the
appropriate policy rate should be in late 2015 and where the policy
rate will actually be, using the Bank of England’s methodology for
converting large scale asset purchases into policy rate space. The
way this can be understood is via an increase in the coefficient on
the output gap term in the Taylor rule, from 0.5 to 4.6. Our chief
US economist, Michael Feroli, thinks that the Fed’s own assessment
of what the balance sheet will be worth in policy rate space in
late 2015 is around 100bp, around a third of what the Bank of
England’s methodology would suggest. If this were the case, then
the increase in the coefficient on the output gap term in the
Taylor rule would be from 0.5 to 3.3.
Although it looks like
the shift in the Fed’s reaction function is much larger than the
shift in the Bank of England’s reaction function, it is not clear
that this would be the right interpretation. We have no idea how
the Bank of England’s balance sheet will evolve as the output gap
starts to close. Any central bank which keeps the policy stance
steady as the output gap closes and inflation moves towards the
long run objective is effectively increasing the weight on the
output gap term in its reaction function. In any event, this
analysis shows that the ECB could do a lot, lot more, either in the
present or in terms of commitments about the future, and still
remain broadly in line with what is going on
elsewhere.
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