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The US Federal Reserve's cunning plan

| Posted by: Paul Donovan | Tags: Paul Donovan Weekly

  • The latest minutes from the US Federal Reserve discussed plans for Fed bond holdings. The Fed proposed that it will preannounce a schedule of tightening lasting several years, until policy is "normal". Every month, some maturing bond proceeds will not be reinvested. Every three months the Fed will tighten further. 
  • Why is the Fed planning so far into the future? Perhaps the Fed wishes to avoid surprising financial markets. Politics may also play a role, however. Yellen's term as Fed chair and Fischer's term as Fed vice-chair both expire in 2018. There are vacancies on the FOMC. Congress has made suggestions that could undermine the policy independence of the Fed. 
  • Quantitative policy is a normal instrument for a central bank, but in the wrong (politicized, non-economic) hands it is potentially very dangerous. The German Reichsbank's quantitative policy in 1923 had disastrous consequences; the German Reichsbank was run by a lawyer not an economist, so perhaps this is not surprising. 
  • A preannounced quantitative policy tightening path gives insurance against the possibility (however remote) of a less independent Fed. If the current Fed schedules a complete quantitative policy normalization, it will be more difficult for a future Fed to change. The preannounced plan is a smart suggestion.