Is tapering tightening?
Janet Yellen may not get that question in those exact words at her confirmation hearing Thursday, but it is one she will have to answer successfully to succeed if she is installed as the chairman of the Federal Reserve early next year: Is tapering, the process of slowing down the Fed’s monthly stimulus bond purchases, the same as tightening the money supply?
The Fed, under the leadership of outgoing chairman Ben Bernanke, is struggling to pull off a taper without harming the economy. It would be up to Yellen to see it through.
Yellen says she wants to improve the Fed’s communications. “I strongly believe that monetary policy is most effective when the public understands what the Fed is trying to do and how it plans to do it,” she plans to say at Thursday’s hearing, according to prepared remarks released by the Fed.
But doing so is easier said than done, as the past few months revealed.
Bernanke has tried to emphasize at every opportunity that slowing down the purchases won’t tighten the money supply and that it’s the stock, not the flow, of the central bank’s bond purchases that is providing stimulus. He argues that if the Fed reduces the rate at which it buys securities from the current $85 billion a month, it’s not withdrawing stimulus — it’s just adding it more slowly.
At the same time, he wants to transition away from quantitative easing and toward the Fed’s other stimulus tool: promises to keep short-term interest rates near zero. Already the Fed has said it will hold off raising rates until after the unemployment rate falls below 6.5 percent. The jobless rate was 7.3 percent in October.
In July, Bernanke called relying less on quantitative easing and more on forward guidance about rates a “possible change in the mix of instruments,” and said that “shouldn't be confused with the overall thrust of policy, which is highly accommodative.”
In other words, Bernanke wants the public to believe that tapering is not tightening the money supply.
Investors have not complied, though.
In June, when Bernanke set out a timeline at a press conference that made it seem as though the taper was imminent, markets tanked.
In September, when the Fed didn’t scale back, stocks soared on the surprise.
Bernanke has denied it, but if markets hang on every meeting, the Fed may not be sketching out its long-term plans very clearly, and it might have a communication problem.
Clarity hasn’t always been the Fed’s goal. Former chairman Alan Greenspan was famous for intentionally speaking in vague and ambiguous terms. Yellen’s track record suggests that she is serious about moving further away from that practice.
After becoming the Fed’s vice chairman in 2010, she was charged with heading up a subcommittee on communications. Subsequently, she led the effort to establish a 2 percent inflation target, something the Fed didn't officially have before 2010. She also supported the monetary policy committee’s move to tie its forward guidance about interest rates to an unemployment threshold.
The question is whether, with her background of strong support for transparency about what the Fed’s up to, Yellen can improve on Bernanke’s efforts.
Indications are that Yellen would quickly test the strategy of shifting toward interest rate guidance if she became chairwoman. Last November, Yellen called forward guidance the “centerpiece of appropriate monetary policy.”
Two recent studies from top Fed researchers indicate which way the wind is blowing. Both recommend lowering the unemployment threshold for the increase in short-term interest rates from 6.5 — effectively pushing that date out further.
Goldman Sachs economist Jan Hatzius commented in a research note that the studies “considerably increase the probability that the FOMC will reduce its 6.5 percent unemployment threshold for the first hike in the federal funds rate, either coincident with the first tapering of its QE program or before.”
Pulling off such a switch from relying on quantitative easing to leaning on forward guidance to boost the economy would require Yellen to have a lot of credibility in the stock markets.
Thursday’s questions from senators will be the first real test of whether she has the communications skills to succeed where, so far, the Fed has struggled.