Why policymakers dislike sudden policy rate changes

Market Realist

Dr. Stein on monetary policy communication: Overview (Part 7 of 8)

(Continued from Part 6)

Gradualism

In the case of Quantitative Easing 3 (or QE3), the Committee’s monetary policy decisions have been based on market signals. In turn, the markets have reacted to these decisions, which made the feedback process a vicious circle. However, Dr. Stein argued that this is not always the case.

He quoted a well-known phenomenon of “gradualism” in monetary policy to support his argument. Gradualism refers to a situation where changes in policy rates, during easing and tightening of monetary cycle, come in a series of small and relatively predictable changes. He argued that the Committee’s behavior is “inertial” during normal times. In other words, the Committee dislikes making sudden and large changes in the federal funds rate during normal times. One reason behind the “inertia” is that sudden and large changes in the federal funds rate have a large effect on long-term rates and credit conditions leading to the Fed’s reduced ability to achieve its dual mandate of full employment and moderate inflation.

Another support for “gradualism” is in the market expectations. When the Fed increases the federal funds rate at the beginning of the tightening cycle, markets start expecting that the rate increase will be followed by further rate increases making it easier for the Fed to implement the changes.

The more the Fed shows aversion to large changes in the federal funds rate, any small change is more significant and markets expect an increase in similar changes. As a result, gradualism is important for the policymakers to fulfill market expectations and avoid volatility in the markets.

Gradualism created havoc in bond markets when it was first hinted at during the Fed’s June 2013 meeting, which led to a fall in 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), the markets have come to terms with tapering and expect the same rate to continue. This can be seen as a gradualist move on the Fed’s part.

To learn more about Dr. Stein’s suggestion of an alternative approach, continue reading the next part of this series.

Continue to Part 8

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