The Federal Reserve refrained on Wednesday from reducing its experimental bond purchase program, thus maintaining its unconventional support for markets and the economy. In doing so it is probably signalling more than continuing worries about America’s tepid recovery, high unemployment rate and the risk of another round of self-manufacturing problems courtesy of Congress. It may also be signalling its concern about triggering renewed financial volatility that would undermine growth, job creation and global financial stability – worries that are unlikely to dissipate easily given the different reaction functions of the economy and markets.
Starting in the last few months of 2008, the Fed successfully normalised markets whose functioning was severely stressed by the global financial crisis. It pivoted in 2010 to the more ambitious goal of using unconventional monetary policies to deliver better economic outcomes; and did so with little policy support from other government agencies with better tools, but constrained by political polarisation.
With economic outcomes repeatedly falling short of their expectations, central bankers got dragged ever deeper into policy experimentation, including an $85 billion monthly bond-buying programme (known as “QE3”). Despite all the bold and innovative policy measures, however, they are still not in a position to declare a comprehensive victory.
Undoubtedly, the Fed has provided crucial time for endogenous healing while turbocharging risk assets. However, the resulting balance sheet repair has proved insufficient to decisively pull the economy out of a low-level growth equilibrium that creates too few jobs and contributes to income inequality. Indeed, Fed officials again had to lower their projections for the economy.
In the meantime, they will worry even more about the risk of collateral damage from such highly-experimental policies (eg, the risk of fuelling excessive financial risk taking, contributing to resource misallocations, and undermining the functioning of markets).
In balancing the “balance, costs and risks,” the Fed is not yet comfortable to do what many, includingme, had expected – namely embark on a “Taper Lite” involving an initial $10bn-$15bn cut in monthly purchases. I suspect that the decision may well have been heavily influenced by how the mere mention of a taper back in May contributed to significant financial market instability, both in the US and abroad.
Essentially, the Fed is dealing with a reality that is well known to students of economics: financial markets can react a lot quicker than the real economy. So, while the Fed is focused on calibrating its gradual transition out of QE with economic conditions (the “journey”), market participants are much more inclined to rush to what they deem to be the “terminal values” (the “destination”).
This basic difference is highlighted by how, notwithstanding a broadly unchanged outlook for the economy, the 10-year Treasury bond rose by around 100 basis points after the taper talk. The interest-rate sensitive segments – which had been bright spots – are already feeling the negative impact. Witness, for example, the 14 per cent decline in home purchase applications, 66 per cent drop in the refinancing index, and 18 per cent fall in home affordability.
Given these realities the Fed is not quite ready to embark on what will be a multi-stage journey out of unconventional policy – one that will sequentially involve the taper, less accommodative forward policy guidance and then normalising the fed funds rate. This is a journey that will take a few years. It is also fraught with risk and uncertainty.
In postponing the taper, the Fed only delayed what many market participants will continue to expect. This will not alter the prospects for the economy in any fundamental manner though it impacts financial markets. Indeed, the Dow hit an all-time high just after the Fed’s policy announcement. The Fed will thus need to monitor even more carefully domestic and international reactions, particularly those with large network effects and quick feedback loops.
The Fed’s greatest challenge is not in deciding on the optimal month to start the taper, as hard as this may be. It is in balancing its focus on a carefully-crafted journey (namely a gradual, measured and conditional normalisation of monetary policy) with the markets’ natural inclination to jump quickly to the destination (thereby risking to pre-emptively impose market-determined terminal values on a still-fragile economy). Unfortunately, there is no easy way to reconcile the two, regardless of how long the first taper step is delayed.