Goldman’s Call Of Possible Shift In Fed Policy

What might be the next move by the all powerful Federal Reserve as it goes about trying to nurse our economy back to health?

Mike O’ Rourke, chief market strategist at Jones Trading recently highlighted that the folks at Goldman Sachs believe Fed policy may be set to shift. I mean, who on Wall Street might have the ear of the Fed more than the folks at Goldman, right? Ok, ok, enough of the sarcasm.

Let’s navigate as O’ Rourke interprets Goldman’s reading of the Fed’s tarot cards regarding future monetary policy.

Goldman Sachs’ call that Fed policy may be set to shift. The crux of the forecast is that the Fed will likely lower the Unemployment Rate threshold (currently at 6.5%) necessary to end zero interest rate policy (ZIRP) in combination with tapering quantitative easing, and that this increases the probability of a December taper.

Two Fed papers (Paper 1, Paper 2) to be presented at an IMF conference this week serve as the foundation for the new forecast. Much of this is rooted in the “optimal control” approach to policy believed to be favored by incoming Fed Chair Janet Yellen.

Goldman suggests that under the optimal policy, ZIRP would remain in effect until 2017. If this shift were to occur, it is the reengagement and escalation of the trend of FOMC policy prior to the September meeting. In essence, it is the reduction of QE in favor of additional forward guidance.

Sounds to me like Goldman portends that the Fed is trying to transfer the patient, that is our economy and our markets, from the potent juice embedded in its QE program to the slower but longer drip of “free money” that comes with a zero interest rate policy. O’ Rourke uses a more comical analogy.

It is reminiscent of Wimpy, Popeye’s buddy, telling you, “I’ll gladly pay you Tuesday for a hamburger today.” The Fed will gladly promise ZIRP for the next four years in exchange for your QE today. Wow, that would be 8 years of ZIRP. That certainly sounds very Japan like, and we don’t mean the Japan of 2012-2013.

Normally, we would say it is surprising for “optimal control” to become the cornerstone of FOMC policy. In the speech Janet Yellen gave on the topic last year, she asserted that “While optimal control exercises can be informative, such analyses hinge on the selection of a specific macroeconomic model as well as a set of simplifying assumptions that may be quite unrealistic. I therefore consider it imprudent to place too much weight on the policy prescriptions obtained from these methods, so I simultaneously consider other approaches for gauging the appropriate stance of monetary policy.”

To take over as the most powerful Central Banker in the world and transition to a policy approach she herself described as imprudent seems unlikely. Obviously, we like to take common sense view, but that does not fare well with the way this Fed implements policy. The one key trait this Fed has exhibited is a lack of consistency. It has been fairly common to move the goal posts in pursuit of easier policy. The two most glaring examples in 2013 are the “stale” exit strategy that was never updated, and of course, the non-taper in September.

In typical Fed irony, Yellen described what is necessary for optimal control to work “In effect, this approach assumes that the policymaker has perfect foresight about the evolution of the economy and that the private sector can fully anticipate the future path of monetary policy; that is, the Central Bank’s plans are completely transparent and credible to the public.”

Of course, we are all aware the Fed has had anything but perfect foresight and transparency.

In my humble opinion, I believe the Fed is very concerned about asset bubbles across a wide swath of our markets while simultaneously being equally concerned about the general economic malaise that will likely persist and may worsen as Obamacare is rolled out. How does the Fed ease the air out of the bubble while simultaneously keeping its monetary policy accelerator open to full throttle? Just as described by the folks from Goldman.

Additionally, I think we will hear more saber rattling regarding the likelihood of tapering, so as to keep the markets in check while actual tapering will be pushed off further into the future. Look for the yield curve to steepen (longer rates inching higher marginally relative to short term rates) somewhat in the process.

By Larry Doyle