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In Advance Of Bernanke's Speech At The Boston Fed Submitted by Tyler Durden on 10/14/2010 22:59 -0500 Ben Bernanke Gross

Domestic Product LBO Monetary Policy Nominal GDP Quantitative Easing San Francisco Fed Unemployment Readers have already likely had the chance to read the official Fed mouthpiece's bulletin on what to expect out of Bernanke's speech tomorrow at the Boston Fed. Since as we have disclosed previously anything that comes out of the WSJ on the topic of the Fed, gets Calvin Mitchell's stamp of pre- and post, approval we ar e positive the propaganda spin is in place: after all, can't make the Fed seem " too transparent." So while we are on the topic, here is Goldman's Sven Jari Steh n to confirm just what is best for the bankers: here it goes "For example, Glen n Rudebuschs analysiswhich assumes that Fed purchases have larger effects on the eco nomy than we estimateimplies that the Fed would need to buy around $2tr of additio nal assets to compensate for the zero bound."Did Goldman just informally double its QE2 expectations, and implicitly bring the 30 Year rate to zero, now that th e Fed will have to buy every single treasury out there within its SOMA limit (oh yeah, that 35% SOMA cap - we give it 6 months). Fed Chairman Bernankes speech tomorrow on tools and objectives of monetary policy will provide an opportunity to shape the policy outlook. The speech is likely to include comments on additional asset purchases as well as other options such as price level or nominal GDP level targeting.

An additional approach to achieve a further drop in fed funds rate expectations and boost financial conditions would be for the chairman to discuss optimal moneta ry policy models which suggest that the warranted fed funds rate is currently deeply egative. Our optimal policy models have two implications. First, interest rate hikes will no t be appropriate for a long time to come. For example, under our own economic f orecasts it might take until 2015 or longer before a rate hike became appropriat e (although we emphasize that this is a scenario projection built partly on assu mptions about fiscal policy rather than a formal forecast). Second, substantial asset purchases would be required to make up for the constraints imposed in the interim by the fact that the funds rate is at the zero boundwhich is why we expec t the Feds expected purchases of US Treasuries eventually to cumulate to $1tr and possibly a lot more. Fed Chairman Bernanke will speak at a conference in Boston tomorrow morning, pro viding an opportunity to discuss his views on the monetary policy outlook. He c learly intends to do this, as the title of his speech is Monetary Policy Objective s and Tools in a Low-Inflation Environment. In his speech the chairman is likely t o include comments on additional asset purchases as well as other options such a s price level or nominal GDP level targeting. However, as discussed in Tuesdays D aily Comment we think that it is unlikely that the Fed will adopt price or nomin al GDP level targeting any time soon. Rather, we see their mentioning as a sign al that the Fed has plenty of options left to boost the economy.

An additional approach to provide guidance to markets and achieve a further drop in fed funds rate expectations, would be for the chairman to discuss optimal mone tary policy models (see Sealing the Case, US Views, October 11, 2010). We have repeat dly argued that such models imply that the warranted federal funds ratei.e. the rate ppropriate if no zero lower bound existedis deeply negative and should remain well below zero for a long time to come. This conclusion is robust across framework s and forecasts used to derive it.

The starting point of this analysis is the so-called Taylor rule, which relates the fed funds rate to inflation and economic slack in the economy. Our version of t his rule, which relates the funds rate to the concurrent unemployment gap (the d ifference between actual and structural rates) and core PCE inflation, suggests that the Fed would have cut the funds rate to -4?% were it not for the zero lowe r bound. Glenn Rudebusch of the San Francisco Fed similarly concluded that the warranted funds rate is around -5% (see The Feds Exit Strategy for Monetary Policy, F BSF Economic Letter, Number 2010-18, June 14, 2010.) Our preferred rule, however , is a forward-looking specification which links the funds rate to expectations of f uture inflation and unemployment. (For details see The "Warranted" Funds Rate: Is It Really Negative?, US Daily Comment, March 10, 2010.) Given our outlook of fall ing inflation and further increases in unemployment, this rule points to an even more negative rate of -6?%. While the FOMCs latest (June) forecasts imply a fund s rate not as negative as ours, these projections are in flux. We expect a mean ingful downgrade of these forecasts (which will be published at the November FOM C meeting) which should result in a warranted rate which is 1-2 percentage point s less negative than that implied by our own economic forecasts. This Taylor rule approach, however, likely overstates the need for additional mo netary stimulus because the economy is also receiving boosts from unconventional monetary policy and, at least until recently, from expansionary fiscal policy. Earlier this year we therefore constructed an estimate of the overall macroecon omic policy stance, which takes into account not only the position of convention al monetary policy but also the Feds quantitative easing and fiscal policy. Our a nalysis found that the overall policy stance can be expressed as a weighted aver age of the real fed funds rate (with a 40% weight), the impact of Fed MBS purcha ses on the mortgage/Treasury spread (40% weight) and the cyclically adjusted bud get balance (20% weight). In the spirit of the Taylor rule, we then related thi s measure of the overall policy stance to expectations of inflation and the unem ployment gap as a description of how overall macro policy has behaved in the pas t. (See No Rush for the Exit, Global Economics Paper, No. 200, June 30, 2010.) Aga in our conclusion was that although the current overall policy stance is very ea sy by historical standards it is not quite as easy as past behavior would sugges t. In other words, while the Fed purchase program and the fiscal stimulus helpe d provide a substantial amount of stimulus, the response did not quite compensat e for the fact that the federal funds rate hit the zero bound. This analysis su ggests that the current warranted funds rate would be -3?%a rate somewhat less neg ative than that implied by our Taylor-rule analysis. (Again this warranted rate would probably be 1-2 percentage points less negative if we used the FOMCs yet-to -be-released new economic forecasts.) These models have two important implications. First, interest rate hikes will n ot be appropriate for a long time to come. For example, under our own economic forecasts it might take until 2015 or longer before a rate hike became appropria te (although, as discussed in the Global Economics Paper cited above, this is a scenario projection built partly on assumptions about fiscal policy rather than a formal forecast) [TD: yes, yes, we get it].

Second, substantial asset purchases would be required to make up for the zero bo und. This is, of course, the reason why we expect the Fed to eventually buy mor e (and possibly a lot more) than $1tr of longer-term assets. A while ago we est imated that the Fed would have needed to buy an additional $5tr or more in 2009 to compensate for the fact that the funds rate could not be cut to its warranted level (see What Does It Take to Beat the Zero Bound?, US Daily Comment, April 13, . The fact that policymakers did not adopt such an aggressive approach suggests that they were concerned about the unwanted side effects of such a policy, incl uding the potential for renewed Fed-induced asset bubbles or the risk of large l osses on the Feds asset portfolio. An optimal policy which takes these costs into ac ount would therefore not attempt to compensate fully for the zero bound (see our Global Economics Paper, cited above). For example, Glenn Rudebuschs analysiswhich

assumes that Fed purchases have larger effects on the economy than we estimateimpl ies that the Fed would need to buy around $2tr of additional assets to compensat e for the zero bound (see paper cited above). By presenting his own version of this type of analysis, chairman Bernanke could probably achieve a further drop in fed funds rate expectations and boost financi al conditions. In fact, discussing optimal policy models might be a preferable way to ease financial conditions than talking about price level or nominal GDP level targeting, because the implied policy does not require a change in the Feds targe ting framework (as it is based on historic Fed behavior). And such a discussion would not be a commitment because it would be based on uncertain economic forecasts . But a detailed explanation by Bernanke of just how long the funds rate might stay near zero could be a valuable complement to a November QE2 announcement. ... Alternatively, the Fed chairman can just print a check for $100 trillion and LBO the world using another $900 trillion in 0% perpetual UST consols, AAAA+ rated by both S&P and Moody's. Ultimately, it will pretty much achieve the same task.