This week’s meeting of the FOMC, the Federal Reserve’s monetary policy committee, speaks volumes to the policy dilemma facing highly activist central banks. Let us hope other policymakers and, even more importantly, their political bosses are listening.
In the run up to the meeting, there seemed to be enough data to warrant additional policy measures – from weakening economic activity (domestically and around the world) to more subdued inflation. Along with European financial fragility, this led analysts to speculate about additional measures. Equity markets rallied, as did other risk assets, helped also by signals out of the European Central Bank. Yet, when push came to shove on Wednesday, the Fed was restrained, and understandably so.
For several years now, the Fed has been leading the policy parade. The initial focus (2008-09) was to counter market failures, system fragmentation and technical contagion that erupted in the midst of the global financial crisis. And it delivered, helping to avoid a global depression.
Fed officials did not stop there. Bolstered by their successes and, more importantly, feeling they must compensate for the paralysis of other US government entities, they shifted in 2010 to a more direct targeting of economic outcomes. Here, however, they have repeatedly disappointed – both in absolute terms and relative to their own expectations.
While some would have favored even greater policy activism, the Fed’s measures have been unprecedented – from flooring policy rates virtually at zero for quite a while (and also providing forward guidance until the end of 2014) to ballooning its balance sheet in an attempt to counter the de-leveraging of the private sector and induce it take more risk. In the process, it transitioned from completing dysfunctional markets to dominating some of their functioning; and it is sowing the seeds of possible policy complications down the road while exposing itself to greater political intrusion, undermining the price discovery process, and distorting asset and resource allocations.
So while markets have been conditioned to expect ever greater central bank intervention whenever the data weakens or sovereign spreads spike in Europe, the cost-benefit equation within the Fed has gotten considerably trickier. There is now much greater appreciation that the policy response, no matter how imaginative, can do little on its own to address decisively America’s challenges of too little growth and employment, too much long-term debt and too great a political polarisation.
So, this time around, the Fed decided to talk the talk but not walk the walk. It is unwilling to do anything now, also reflecting a desire to keep dry whatever policy ammunition remains in the event that Washington is unable to deal with the fiscal cliff and Europe takes another turn for the worse. And while it signaled a willingness to do more should conditions deteriorates, I suspect that it wishes this to be in support of other policy measures rather than substituting for them.
The Fed’s attempt to overcome its policy dilemma has little chance of succeeding given the degree of political dysfunction in Washington. It is only a matter of weeks until, once again, Fed officials will feel compelled to act, and despite full knowledge that their measures will have limited effectiveness in delivering desired outcomes.
Most fundamentally, what is being illustrated again in all this is that what the US faces today is as much a political problem as it is an economic one. Until the political system steps up to its strategic leadership challenge, America will risk the trap of policy purgatory.