The economist credited with helping encourage the Federal Reserve to take a new, bold approach to monetary policy says the latest plan to buy bonds will prove more effective than past efforts to boost the U.S. economic recovery.
Taking a page from the academic paper presented to the central bankers’ conference in Jackson Hole, Wyoming in late August by Michael Woodford, the U.S. central bank on Thursday said it would continue to buy financial assets until there is a “substantial” improvement in the labor market. The Fed also said it would keep interest rates very low well after the economic recovery strengthens.
At a press conference in Washington, Fed chairman Ben Bernanke cited Mr. Woodford’s research and called him a friend as he explained the conditions attached to the Fed’s third round of bond buying, known as quantitative easing, or QE3.
Mr. Woodford, a Columbia University professor and one of the foremost thinkers on how economies can escape from the threat of deflation, welcomed the Fed’s new approach and predicted it would help stabilize financial markets no matter what news - good or bad - is on the horizon.
“The uncertainty about how things might be unfolding next is one of the biggest obstacles to the economy improving, so how you affect perceptions is really critical at this point to what they’re trying to do,” he said.
Unlike the Fed’s first two rounds of quantitative easing, in which the Fed bought about by $2.3-trillion worth of securities over time, Mr. Woodford argued that the plan unveiled on Thursday would not give the impression that the central bank has grown more pessimistic about the economy.
The central bank’s new strategy assures individuals, businesses and investors that it is committed to both act, and then to shut down its unconventional policy actions when the time is right, Mr. Woodford said.
“They’re making bad news less destabilizing in one direction, and making really good news less destabilizing in the other direction,” he said.
On the other hand, the first two rounds of Fed bond purchases as well as the Fed’s series of conditional pledges to keep interest rates low until a future date - the latest of which is mid-2015 - could be interpreted as “reason to wait and delay future spending,” Mr. Woodford said.
The U.S. economy is forecast to grow at around 2 per cent this year, a better rate than is expected in most European countries. But the euro zone crisis and the so-called “fiscal cliff” of possible U.S. tax rises and spending cuts due in early 2013 threaten to derail the U.S. economic recovery.
The Fed’s third round of quantitative easing kicks off with $40-billion in purchases of mortgage-backed securities per month, an aggressive and “open-ended” plan to boost the sputtering economic recovery and to get Americans back to work.
Asset purchases will continue “if the outlook for the labor market does not improve substantially,” the Fed said on Thursday, adding it expects “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”
At his press conference Mr. Bernanke cited Mr. Woodford’s recent paper on monetary policy options when interest rates are near zero. The paper argued the best way to defeat stubborn economic weakness is to keep monetary policy very stimulative for longer than would be advisable under typical rate-setting rules which weigh both growth and inflation.
“I think the thrust of his research is that forward guidance and communication about future policy is in fact the most powerful tool that central banks have when interest rates are close to zero,” Mr. Bernanke said, calling Mr. Woodford, a former colleague, co-author and friend.
Woodford, for his part, was quick to credit another respected economist who has pushed to tie Fed policy even more explicitly to specific economic yardsticks: Chicago Fed president Charles Evans.
Mr. Evans, one of the most dovish of Fed policy makers, has for a year advocated that the central bank promise to keep an easy money stance until either the jobless rate falls to 7 per cent or inflation rises to 3 per cent. U.S. unemployment is now 8.1 per cent and inflation is below the Fed’s 2 per cent target.
“They’re clearly saying both of the things Mr. Evans was suggesting, it’s just that they’re not saying it with the numbers,” Mr. Woodford said of the Fed’s policy-setting committee.
“I would certainly read it as a very close cousin to what Evans was proposing to say, except stating it in general terms rather than with numbers.”
Time will tell whether the Fed’s new brand of easing has a more direct influence on the economy, or whether it dulls the erratic reactions that financial markets have had to past asset-purchase plans.
The S&P 500 stock index reached its highest level in nearly five years on Thursday, while U.S. Treasury bond prices ended the day mostly higher.
“To the extent this strategy works, history may look back on Mr. Woodford’s Jackson Hole advocacy of conditional commitment as a turning point in the way the Fed attacked the sluggish recovery,” wrote JPMorgan economist Michael Feroli in a research note.
“To the extent this strategy doesn’t work, at least Bernanke can argue that he threw everything he had at the problem.”
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