The minutes of the US Federal Reserve released on Wednesday are an essential read for those interested in a real time snapshot of the complexity of modern day central banking. They are also a cautionary note for all who believe that, acting on their own, today’s hyper-active central banks can engineer good economic outcomes.
While the Fed is already deep in experimental mode, the minutes confirm that officials there are already considering additional measures. There are two reasons for this. First, their baseline economic expectations remain subdued as more positive housing and consumption indicators are offset by slower business activity. Second, they recognise the “significant downside risk” to the baseline forecast due to the global economy’s synchronised slowdown and the possibility of further financial shocks, such as the US falling off the fiscal cliff.
The minutes also reveal considerable confusion as to what exactly the Fed should do next. With interest rates at zero and forward interest rate guidance already extended to mid-2015, policy is faced with a shrinking set of options. This includes evolving further its communication role by moving to “quantitative thresholds” (ie, specific targets for the unemployment rate and inflation or, alternatively, for a broader concept such as nominal GDP); and/or expanding the programme to purchase securities on the open market (or “QE3”) in order to change the private sector’s behaviour.
While many Fed officials appear to favour additional policy activism, the minutes cite the need “to resolve a number of practical issues” before taking another major step. That is not surprising. What the Fed is now considering is fraught with even greater operational complexity. And this applies to both components.
As regards communication, the challenges go well beyond the tricky specification of the quantitative thresholds. Should the Fed target actual or forecast levels? Should its policy reaction function involve a glide path or a step function? How conditional should its commitment be?
The Fed is also running against practical concerns when it comes to the possibility of more QE. Already, its large purchases have turned this traditional referee into a non-commercial player with influential ownership of many individual market issues. The Fed has imposed a sizeable footprint on the markets for US Treasuries and mortgages. In doing so, it has altered not only valuations but also the efficient functioning of markets. As such, it is also far from straightforward to expand the institution’s securities program without creating significant damage.
As real as these problems are, they pale in comparison to what is really at issue: the worrisome signal that – with other policymakers essentially missing in action and politicians again playing Russian roulette with the economy – influential members at the Fed feel that they have no choice but to do more using imperfect, untested, partial and, potentially, risky tools.
This policy dilemma is amplified by the fact that, until now, the Fed’s unusual policy activism has failed to deliver the growth and employment results that its policymakers expected. At best, Fed officials have provided more time for the system to heal, but at the risk of growing collateral damage and unintended adverse consequences.
Judging from the minutes, some Fed officials are worried, questioning “the effectiveness of current purchases.” Yet this will not stop the institution from implementing additional highly experimental policies – and not because it wants to but, rather, because it feels it has no choice but to do so. And it could happen as early as the December or January Fed policy meetings.
Expect the Fed to move to quantitative thresholds, announce additional outright purchases of securities, and reintroduce Treasuries to their list of targeted instruments. But unless (and until) politicians and other policy making entities step up to their responsibilities, this unusual policy activism will fail to deliver the economic outcomes that the country needs and deserves.