Yesterday the Fed pirouetted neatly, simultaneously beginning to taper its quantitative easing and suggesting that policy will not tighten until well beyond its guidance threshold for unemployment. The sum impact has been a loosening of policy but what interested me is the sequencing of its actions.
Consistent with the comments of Don Kohn the Fed’s first move in a while has been to reduce the scale of QE. Kohn suggested that the unwinding of QE should precede the lifting of interest rates to reduce distortions in bond markets. This takes that idea a step further: having seen the success of forward guidance in recent times the Fed has shifted its stimulus away from asset purchases and towards a greater reliance on forward guidance. So far it appears to have succeeded.
The move will be watched closely in the UK, where the recent one-month unemployment figures touched the Bank of England’s guidance threshold of 7 per cent. If the trend continues then we could see the guidance threshold broken within a year of being implemented. That risk is likely to be behind the strong hints from the Bank that it is unlikely to begin tightening for some time after the guidance threshold is broken. Essentially, it is trying to informally extend its forward guidance.
The difference in the UK is that the Bank of England has rejected Kohn’s idea and claims that interest rates should move first. Mark Carney reiterated this position at the House of Lords hearing earlier this week. Under vigorous questioning from Lords Lawson and McFall he indicated that the MPC view QE as something of a ticking bomb. Markets’ nervous reaction to the prospect of Fed tapering earlier in the year has made the MPC very wary of touching their £375bn of QE. Interest rates are the known quantity and the MPC prefers to lift them until they are well off the zero bound before beginning asset sales. The hope is that the market reaction to easing can be bedded in through the known channels before the QE is gradually unwound in a less volatile environment.
This is a question that only time can provide an answer to. One thing that is certain is that expectations have proven to be the most powerful tool in the central bank’s arsenal. It was not the tapering that touched off a stampeded in the US earlier in the year but talk of potential tapering. Now that actual tapering has begun the market is placing more emphasis on the FOMC’s softening of the guidance threshold than the reduced rate of asset purchases. Carney is right to be concerned but the nuclear tool isn’t unwinding, it is his words themselves.