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The Fed: QE Done, Lift Off to Come?

Donald Kohn

The year 2014 was marked by some important transitions for the Federal Reserve. In personnel, Ben Bernanke stepped down as Chairman when his term was over at the end of January to take up residence at Brookings, and Janet Yellen, who had been vice chair, succeeded him. In policy, The Federal Open Market Committee (FOMC) successfully ended its securities purchases, completing the tapering off of such purchases that started at the beginning of the year, and capping its securities portfolio at a mere $4.2 trillion at the end of October, up from $480 billion just seven years earlier. And, as the economy gradually came closer to the Fed’s interpretation of its Congressionally-mandated dual objectives of maximum employment and stable prices, it adjusted the way it characterized its intentions about holding its policy rate near zero. The issue facing the monetary policymakers in 2015 will be when to begin to raise policy interest rates, which have been close to zero since the fall of 2008 after the market panic that followed the bankruptcy of Lehman Brothers.

The transition from Ben Bernanke to Janet Yellen has been marked by continuity and consensus. Like Chairman Bernanke, Chair Yellen has led the FOMC as a consensus builder. She has reached out to the 12 Reserve Bank presidents as well as her fellow governors on the Federal Reserve Board in advance of FOMC meetings to gather ideas and gauge developing views. In her press conferences, she has been careful to represent the center of gravity on the FOMC, and her speeches on topics central to the determination of monetary policy, such as developments in the labor markets, have been nuanced to reflect an array of possible interpretations of the degree of slack. Yes, there have been dissents from FOMC decisions, but they have been on both sides—desires both to signal earlier tightening and to signal that easier policy will last for longer—and a wide variety of strongly held views is not unexpected or undesirable when the FOMC is operating in such unfamiliar policy territory.

Continued improvement in the economy in 2014 and good progress toward the Fed’s goals of an unemployment rate in the 5.2 to 5.5 percent range and inflation (measured by the PCE [Personal Consumption Expenditures] chain price index) at 2 percent meant that the FOMC could end one leg of its unconventional monetary policies, asset purchases—so-called (not by the Fed) quantitative easing, or QE. Ending these purchases didn’t mean that the Fed was tightening policy—it continued to hold these securities off the market—but it did mean that it judged that added downward pressure on long-term interest rates was no longer needed to support the economic expansion. The pace of job creation picked up from around 195,000 per month in 2013 to around 240,000 per month so far in 2014; the unemployment rate fell from 6.7 percent at the end of last year to 5.8 percent in November on the usual measure and from 13.1 percent to 11.4 percent on a broader measure which includes discouraged workers and those working part-time for economic reasons. The CPI (Consumer Price Index) measure of inflation fell from 1.5 percent to 1.3 percent in November relative to a year ago on the back of a sharp decline in energy prices; core CPI inflation, taking out food and energy, rose 1.7 percent November over November, about the same as in December 2013, but at least it wasn’t moving down as in so many other countries. The PCE targeted by the Fed accelerated slightly through October, the latest data available, to 1.6 over a year ago in the core measure.

What was behind the improvement in labor markets and stable-to-firming underlying inflation pressures? In the fifth year of expansion from its deepest post-war recession, the US finally faced a number of favorable underlying factors. First, households had reduced their debt levels relative to income, were experiencing both rising wealth as equity and house prices increased under the impetus of very low interest rates and higher incomes as employment gains picked up, and as a consequence were in a better position to step up borrowing and spending. Second, lenders, having recovered from the losses of the recession, looked at stronger demand for credit, and trying to find higher yields in the low interest rate environment, increased the supply of credit, loosening the terms and standards they imposed on loans. And third, government on all levels—federal, state, and local—stopped raising taxes and reducing spending, so their actions were no longer a drag on growth. As the amount of slack in labor markets and economy gradually eroded, we began to see scattered early signs that wage and compensation rates might be picking up, supporting expectations of a very gradual upward movement to 2 percent inflation.

All this is expected to continue into 2015, providing a solid base for sustained good growth and a pickup in underlying inflation. In addition, the recent sharp drop in energy prices will add further to the purchasing power of household incomes, supporting greater spending. And if that’s all we anticipated, the Fed could exit from the other leg of its unconventional policy—near zero interest rates and the promise to hold them there—readily in 2015 while the economy continued to progress toward the Fed’s two goals in labor markets and inflation.

There are however, some clouds on the horizon that justify the question mark in the title of this piece—developments that raise doubt about whether conditions will be right for the Fed to be able to lift its policy rate off of zero this year. And those clouds mostly reflect troubling developments outside the borders of the US. Global growth has slowed in 2014. Both Japan and the euro area experienced quarters of GDP decline; while monetary ease has been stepped up in both jurisdictions, whether it will be enough to restore decent growth is not yet clear. A number of emerging market economies are facing challenges as well: growth in China has slowed more than expected as the Chinese economy makes its transition from export-led to domestic demand-driven growth and from investment to consumption within domestic demand, all the while trying to move its shadow banking system back to the books of banks and further liberalize the financial system; Brazil and some other large emerging market economies (EMEs) are also coping with disappointing economic performance; and of course Russia is feeling the effects of both sanctions and the plunge in oil prices. Lower energy prices will help oil and energy importers, but at the expense of oil exporters.

Responding to both weaker prospects in the rest of the world and to flight to the safety and liquidity of dollar assets as volatility and geopolitical risks have mounted, the dollar has strengthened considerably this year. This will add to the effects of slower growth abroad in holding back our exports and will rechannel a portion of domestic demand in the US toward imports and away from US producers. Geopolitical and as well growth concerns could undermine confidence and reduce the appetite of lenders and investors for taking risks—and we’ve seen signs of the later popping up in what are already more volatile financial markets.

Although lower energy prices should be only a temporary depressant on US inflation, if low incoming inflation data causes a drop in longer-term inflation expectations, that could threaten the timely return to a 2 percent inflation path. We’ve seen some signs of a decrease in inflation “compensation” imputed from securities prices, but those prices are subject to a variety of forces and so far, survey measures have held fairly firm. Still, this will be an area that the Fed will watch closely as it assesses whether to raise rates.

To date, these global factors seem to be mostly about downside risks rather than about changing the most likely trajectory of the US economy, but they do point to the possibility that the Fed could find itself making less progress toward its goals than anticipated, delaying the date of lift off.

In its December meeting just concluded, 15 of the 17 folks sitting around the FOMC table thought it probably would be appropriate for the FOMC to raise rates for the first time in 2015. Still, Chair Yellen also emphasized the “data dependency” of FOMC decisions, so we will all have to stay tuned for the answer to the question mark in the title.


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