WASHINGTON — Federal Reserve Gov. Jeremy Stein is the latest Fed official to try to explain last week's monetary policy statement and remarks from the Fed chairman, saying unequivocally Friday that despite the outsized market reaction the "fundamentals" of policy are "broadly unchanged."
But while Stein said one should not read too much into the market reaction, he also stressed that the market reaction cannot be dismissed as inconsequential or just noise, since market behavior can affect policy, and it also informs the Fed on how its communications strategy is working.
Fed Chair Ben Bernanke, in his press conference last week explaining the policy decision and outlook for quantitative easing, was making "an effort to put more specificity around the heretofore less well-defined notion of 'substantial progress'" in employment — the Fed's metric for dialing back and ending the asset purchase program — Stein said in a speech prepared for the Council on Foreign Relations in New York.
"We have attempted in recent weeks to provide more clarity about the nature of our policy reaction function, but I view the fundamentals of our underlying policy stance as broadly unchanged," he said.
"So while we have seen very significant increases in long-term Treasury yields since the FOMC meeting, I think it is a mistake to infer from these movements that there must have been an equivalently big change in monetary policy fundamentals," Stein stressed. He added, "Nothing we have said suggests a change in our reaction function for the path of the short-term policy rate, and my sense is that our sharpened guidance on the duration of the asset purchase program also leaves us close to where market expectations — as expressed, for example, in various surveys that we monitor — were beforehand."
Stein explained that policy remains data-dependent and focuses on the accumulation of benefits, not on one or two months of data just before a policy meeting.
"It is important to stress that this added clarity is not a statement of unconditional optimism, nor does it represent a departure from the basic data-dependent philosophy of the asset purchase program," he said.
As the economy gets closer to the Fed's stated goals, including an unemployment rate of 6.5%, he said policymakers can provide more clarity on when they think the asset purchase program will start to wind down and end.
But "the threshold nature of this forward guidance embodies further flexibility to react to incoming data," Stein said. "If, for example, inflation readings continue to be on the soft side, we will have greater scope for keeping the funds rate at its effective lower bound even beyond the point when unemployment drops below 6.5%."
While there are risks to the asset purchase program — he cited potential for financial instability — "thus far I would judge that they have passed the cost-benefit test," he said, noting "some of the brightest spots in recent months have been sectors that traditionally respond to monetary accommodation, such as housing and autos."
Addressing the market reaction to the Fed policy statement, Stein said, "there are limits to how much even good communication can do to limit market volatility, especially at times like these. At best, we can help market participants to understand how we will make decisions about the policy fundamentals that the FOMC controls."
However, he added, "I don't in any way mean to say that the large market movements that we have seen in the past couple of weeks are inconsequential or can be dismissed as mere noise. To the contrary, they potentially have much to teach us about the dynamics of financial markets and how these dynamics are influenced by changes in our communications strategy."
And, he said, "Not only do FOMC actions shape market expectations, but the converse is true as well: Market expectations influence FOMC actions. It is difficult for the Committee to take an action at any meeting that is wholly unanticipated because we don't want to create undue market volatility."
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