I can perform only one magic trick, and it is not a really good one. It involves making a small object, like a coin, disappear.
This rather feeble trick usually works only once on people. And, like other magic tricks, the key is to divert attention during a critical transition phase. Accordingly, you will find me making lots of hand movements and speaking loudly to obfuscate the fact that the coin is being “secretly” transferred either to my pocket or to a sleeve.
At times, policy makers find themselves in the role of magicians, especially when they are pivoting from one well-accepted policy stance to another less certain one. In fact, this is what the world’s most powerful central bank, the US Federal Reserve, will be doing in the next few weeks – perhaps as early as next week (a 50/50 chance), more likely in January and most definitely by the end of March.
As signalled already by Fed officials, and as nearly implemented in September, the central bank is on the verge of altering its policy mix in a material fashion – gradually reducing its reliance on monthly asset purchases (which have been held unchanged at $85bn since the announcement a year ago) and relying more on indirect tools. Put another way, the Fed is seeking to maintain its support for the US economy and markets while reducing the use of a highly experimental tool that, many believe, risks longer-term collateral damage and unintended consequences.
As it is already way deep into unchartered waters, the Fed will be taking this new policy step without the benefit of meaningful historical experiences, tested analytical models or a widely-accepted policy game plan. Accordingly, its initial success will depend in large part on the skillful management of expectations in the private sector – namely, maintaining the private sector’s focus on what the Fed is doing to support the economy and markets, and away from the stimulus that is gradually being taken away.
The importance of the Fed offering something in exchange for the “taper” announcement was vividly highlighted by the experience of the highly dislocated markets in May and June. At that time, investors were alarmed by the mere mention of the word – so much so that, fearing that the Fed would prematurely reduce its exceptional support, they sent virtually all asset prices sharply lower. In the process, they tightened the economy’s “financial conditions”, thus undermining an already-tentative growth and job recovery.
At that time, the Fed had no choice but to react and play massive defence. In July, it clarified its previous communications, including correcting potential misunderstandings on the part of the private sector. It went even further in September when it decided not to taper when most had been conditioned into expecting a modest cut in monthly purchases.
This time around, look for the Fed to be less reactive and much more proactive. Accordingly, in announcing the change to its policy mix, it will likely combine the taper with other (and even more experimental) measures that signal its intention to remain supportive.
Positioned under the impressive and mysterious label of “optimal control”, look for the Fed to strengthen its forward policy guidance, enhance the comprehensiveness of the threshold variables, and reduce the interest it pays banks on excess reserves. In other words, it will seek to minimise any harmful effect from the taper through a firmer anchoring of interest rates on short-dated bonds and by encouraging banks to lend to the real economy.
In purely analytically terms, the Fed will be starting the transition from more to less direct involvement in financial market price formation; and it will do so for both positive reasons (the US economy has been gradually improving) and negative ones (concerns about the potential political, economic and financial risks – real and perceived – of a large and consistently-growing Fed balance sheet). In the process, the overall potency and predictability of its policy stance will likely come down.
While the relative call is clear, the absolute one is not. Specifically, it is debatable whether this new policy mix will be as effective in buying time for the real economy to heal further while, simultaneously, bolstering financial markets as a way of encouraging households to spend (what economists call “the wealth effect”) and companies to invest (triggering “animal spirits”). The related concerns are amplified by the extent to which prolonged Congressional polarisation has paralysed policy making in virtually every other area of importance to the economy.
By following a basic rule of magic, the Fed will look to divert the private sector’s attention from this sad reality for as long as possible.
The writer is the chief executive and co-chief investment officer of Pimco