Economic News & Analysis—August 30, 2012

Deconstructing the Fed: What it means by “soon,” “substantial,” and “sustained”

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

The Fed’s Beige Book—a collection of qualitative assessments of economic and financial conditions in the 12 Federal Reserve Districts—said yesterday that, “Economic activity continued to expand gradually in July and early August across most regions and sectors.”

Compare that statement with what was written in the minutes from the Federal Open Market Committee (FOMC) meeting of July 31 and August 1: “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery.”

“Gradual expansion” is a far cry from “substantial and sustainable strengthening,” but it might be enough to push “monetary accommodation…fairly soon” from the next FOMC meeting (September 12 and 13) to the October meeting. In other words, it’s too soon for more quantitative easing.

Reading the Fed

Hermeneutics is the science of interpreting a text. Reading the Fed minutes is an act of textual interpretation, so economists need to know a little bit about hermeneutics. Is there some secret meaning to the words? What do they really mean? Federal Reserve officials are aware that their words will be sliced, diced, parsed, and pureed.

Keep in mind that the minutes of every meeting are released with a three-week lag. Consequently, the minutes are stale by the time we read them. This is especially true in the most recent minutes, since shortly after the meeting we received data on payrolls, retail sales, inventories, and housing, most of which has been “not bad.” The Fed did not have that data when it met, so the minutes need to be read in light of that fact.

Members and participants

When trying to glean from the text what the Fed’s next move might be, I think it’s important to figure out who said what and how many people agreed. The minutes make reference to “participants” and to “members.” The members are the ones who matter because they voted at the meeting. The members change every year on a rotating basis, so it’s important to keep track of who is a voting member. The participants are not just the 12 voting members, but also the seven other Federal Reserve Bank presidents who attend the meeting. Their views are less important than the voting members’ views.

Quantifying adjectives: From “one” to “all”

The text of the minutes makes careful use of adjectives that refer to quantities. In descending order, the minutes use all, most, many, several, few, some, couple, and one to refer to how many of them expressed, supported, or opposed a particular view. These adjectives do not refer to fixed quantities; however, one, couple, and all should be taken at face value. The others are a little squishier in terms of the quantity implied.

New twists: Soon, substantial, and sustained

The recent minutes state “many members”—and that’s important. “Many” is not as many as “most,” but it’s probably a majority. And “members” means that these were the views that matter: those of the voters.

The new problem of interpreting the text of the Fed is: What is meant by “soon,” “substantial,” and “sustained”?

I think “soon” refers to “before the next meeting.” In other words, if data does not turn from signs of weakness to signs of strength before the September 12–13 meeting, the members would vote to give more monetary accommodation. But the Beige Book now points to a “gradual” expansion. Remember that though it was only released yesterday, the Beige Book was put together on August 20, and the Fed minutes were based on data as of August 1. Now, “soon” may mean October rather than September. That date will continue to move, with positive data pushing it further out in time and negative data pulling it in.

“Substantial and sustained,” I think, need to be read together. Improvements in things like housing sales, payroll growth, retail sales, production numbers, and income figures would all need to happen simultaneously to be considered “substantial and sustained.” Only when the data are moving in the same positive direction could they be considered going the right way—and likely to continue moving that way.

Preference ordering of monetary accommodation

The minutes listed three types of additional monetary accommodation that the members were considering: changing the forward-rate guidance (the “late 2014” language), more bond purchases, and a hodgepodge of other policy options (interest on reserves, lending to loan programs, and so on).

The order the policies were listed in was no accident. Although many members thought more bond buying could be warranted, I think they’ll first try tweaking the forward-rate guidance. Rather than setting a fixed date, I think they want to make the decision conditional on the data. They could do this and explain it at the post-meeting press conference in September. They are likely to say something to the effect that they will keep rates exceptionally low as long as economic conditions warrant. The economic projections provided at the post-meeting press conference can be the vehicle by which the FOMC conveys what is meant by “economic conditions warrant.” Simply, high unemployment and low inflation warrant exceptionally low rates.

As I’ve written before, the Fed does not care that it is an election year. If the data does not continue to improve by October, it would likely make an open-ended commitment to bond buying at its October meeting. Instead of specifying a dollar amount and a time frame over which the buying would happen, it would likely commit to a fixed pace of bond buying per month but with the caveat that it will monitor economic and financial conditions, adjusting the pace as appropriate.

In the end, I do not think it will come to this. As far as I can see, the economic data will not warrant additional intervention beyond changing the forward-rate guidance.

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