Dr. Stein on monetary policy communication: Overview (Part 4 of 8)
FOMC’s reaction function
Policy analysts often talk about the Federal Open Market Committee’s (or FOMCs) “reaction function”—the way FOMC will behave in certain situations. However, Dr. Stein argued that even if each individual member of FOMC has a clear understanding of his or her reaction to a certain economic scenario, the Committee as a whole doesn’t have a clear reaction function.
To have a clear reaction function, the Committee should have debated the pros and cons. Also, it should have buried differences of opinions of individual members so that the Committee can collectively decide on its reaction to a specific scenario. However, due to time constraints, it isn’t usually possible to do that and leave certain differences for further discussion. This makes the Committee’s reaction function be less-than-perfect.
In September 2012, FOMC launched the Quantitative Easing 3 (or QE3) asset purchase program buying Treasury and mortgage-backed securities at a rate of $85 billion a month until there was “substantial improvement in the outlook for the labor market”1. Open-ended asset purchase programs like QE3, which is currently being scaled-down, allowed FOMC to move forward with policy initiative in a timely manner because additional meetings created a platform for discussion on disagreements among the Committee members.
As a result, in its June 2013 meeting, the Fed announced that it will gradually scale-down the QE3 from the end of 2013. Prices of major bond ETFs such as the Vanguard Total Bond Market ETF (BND), the iShares 20+ year Treasury Bond (TLT), the iShares 3–7 year Treasury Bond (IEI), the iShares 7–10 year Treasury Bond (IEF), and the iShares iBoxx $ Invst Grade Crp Bond (LQD) dropped when tapering was hinted at in the Fed’s June 18-19, 2013 meeting on expectation of monetary tightening and the increase in interest rates.
The Committee’s unclear reaction function limits it’s ability to communicate future intentions to the market. The disagreements are also discussed in other meetings, allowing the Committee’s reaction function to evolve with time.
[ 1 From the transcript of Chairman Bernanke's press conference on September 13, 2012]
Browse this series on Market Realist:
- Part 1 - Must-know: Fed communicates intentions to the market
- Part 2 - Must-know: Why the taper caused yields to increase
- Part 3 - Why is the Committee’s forward guidance qualitative?
- Budget, Tax & Economy