QE: A Guide For the Perplexed

The Fed dominated the news cycle last Wednesday. In the morning, Chairman Bernanke appeared on Capitol Hill to discuss the economy and monetary policy. Then, in the afternoon, the Fed released the Minutes for the FOMC meeting held on April 30 and May 1. The stock market initially rallied on Bernanke's prepared testimony, which was interpreted as suggesting that the Fed would not dial down its QE purchases in the near future. But his answers in the Q&A with lawmakers seemed to undercut that notion, and the Minutes went even further by noting that a number of FOMC members were willing to consider tapering as early as the June meeting. The Dow finished the day in the red, after the largest intraday price swing since February.

Press reports the next morning delivered a harsh judgment on the Fed. The headlines included: "In bid for clarity, Fed delivers opacity" (The Wall Street Journal), "Fed endorses stimulus, but the message is garbled" (The New York Times), and "Fed's mixed message takes stocks on a wild ride" (The Washington Post). The consensus was that the Fed had shot itself in the foot.

This consensus, however, is wrong in two ways. First, there was no glaring inconsistency between Bernanke's remarks and the Minutes. Both noted that the economy was continuing to grow at a moderate rate, that conditions in the labor market had shown some improvement but that the unemployment rate remained high, and that the pace of QE purchases conceivably could be reduced as early as the June meeting. This consistency is no accident. When the Fed Chairman testifies on the Hill, he is appearing as the representative of the FOMC; he is not speaking for himself. The Fed's staff - which drafts the Minutes and the Chairman's testimony and which conducts mock Q&A sessions with the Chairman - takes pains to ensure there is only one message. If the Minutes had been released before the testimony, rather than the reverse, observers might have seen more clearly that Bernanke was sticking to the script.

The second misconception is that the Fed would have been dismayed by the market's reaction to the day's events. I seriously doubt that. The Fed has been saying for a while that it could taper the QE purchases sooner rather than later. Indeed, the Minutes to the March 19-20 meeting, released on April 10, noted that:

"Many participants ... expressed the view that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings."

But market observers hadn't fully taken this message to heart. In the Wall Street Journal's latest survey of economists, conducted May 3-7, nearly half of the respondents said that they didn't expect the Fed to slow its QE purchases at any time this year. Given this disconnect, the Fed likely would have been pleased that market expectations adjusted to be more closely aligned with its own thinking.

Looking ahead, how should one gauge the Fed's plans for the QE program and what would be a reasonable guess for the start of tapering?

To judge the Fed's thinking, I would pay attention to the speeches and interviews given by a judiciously chosen set of the twelve Reserve Bank presidents. Their comments are often more revealing than those of Chairman Bernanke and the other Board members who sit in Washington. Bernanke has to be very careful about what he says, both because his words move markets and because he doesn't want to front-run the FOMC's decision-making. The other Board members, whose offices are just down the hall from Bernanke's, have limited latitude to express their own views. The Bank presidents, in contrast, don't work for the Chairman. They are much freer to speak their minds, and they do.

Among the Bank presidents, I would ignore the four hawks (Richard Fisher of Dallas, Esther George of Kansas City, Jeffrey Lacker of Richmond, and Charles Plosser of Philadelphia). They are all thoughtful people with interesting things to say, but their views are too far outside the mainstream to affect FOMC decisions. In contrast, I would listen especially closely to what William Dudley, the president of the New York Fed, has to say. Dudley is a powerful member of the FOMC, and his views about monetary policy are close to those of Chairman Bernanke and Vice Chair Yellen. And, finally, I would follow the comments of four other Bank presidents (James Bullard of St. Louis, Charles Evans of Chicago, Eric Rosengren of Boston, and John Williams of San Francisco). The first three have a vote on policy through year end, while Williams - a nonvoter this year - is an influential voice on the FOMC.

Last Tuesday, Dudley provided important insights into his views. In prepared remarks, he made clear that he would not support a start of tapering in June, as he would need "the coming months" to assess the effects of the ongoing fiscal restraint on the economy. And in a subsequent interview, he was asked point-blank whether tapering could begin in the fall and responded: "I think it's possible ... if the labor market continues to improve and it's supported by economic activity." These comments focus attention on the FOMC's September meeting as the first likely decision point for tapering. Recent remarks by Bullard, Evans, Rosengren, and Williams echo the need for more data before making a decision. Notably, Evans said that he wanted to see whether the improvement in hiring was sustained "through the summer," and Williams said he would be looking for the same pattern over "coming months."

Here's my bottom line. Forget about tapering in June. That was only a theoretical possibility. If payroll gains continue to average more than 200,000 per month over the summer, look for tapering in September. If that test isn't met, the FOMC will evaluate whether to start tapering at every meeting from October on.