By Mohamed A. El-Erian, contributor
FORTUNE — Wow! That is what I suspect many investors said when they heard Wednesday’s policy announcement from the Federal Reserve. And this single reaction would have captured not just partial surprise but also a combination of conflicting feelings.
Have no doubt: Yesterday’s Fed announcement will go down in the history books — at least those texts covering central banking and monetary policy. It marks a major evolution in the activism, involvement and aspirations of the central bank. It is also a risky move, taking the institution much deeper into experimental and politically charged territory.
The Fed took two major steps on Wednesday, one expected and one less so.
First, it added to its expected purchases of market securities, doubling the dollar amount to $1 trillion for 2013 — a very large number by any measure. Second, the Fed shifted to quantitative (unemployment and inflation) targets for forward policy guidance, and it did so earlier than most expected given theoretical and practical complexities.
This further leap into the policy unknown was motivated by continued disappointment with the economy’s sluggish growth, persistently high unemployment and increasing concern about joblessness becoming more structurally embedded into the economy.
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That much was said by Ben Bernanke, the Fed’s admirably transparent chairman, during his press conference after the news was unveiled. It was also obvious that he is very concerned about the fiscal cliff, and the possibility that political paralysis could push the economy into another recession. The accelerated policy implementation may also reflect the Fed’s desire to take out some additional insurance.
Now for the mixed feelings: We should all welcome the greater policy emphasis being placed on unemployment. This national jobs crisis has enormous human costs. It increases poverty. It eats away at the social fabric of our communities. And the longer it persists, the harder it is to solve.
The Fed has again demonstrated to investors that it is “all in.” That is the good news. The Fed is doing even more in its attempt to artificially bolster asset prices as a way to “push” investors to take more risk. The bad news is that the institution, with its imperfect tools for the challenge at hand and with other federal government entities essentially MIA, may be taking on an unsustainable burden.
First, and as recognized by Bernanke, the outcome of the Fed’s unusual activism is neither predictable nor costless. Uncertain expected benefits come with an increasing risk of collateral damage and unintended consequences. And the tricky balance becomes less favorable every time the Fed feels it has to do more because prior actions have not been sufficiently effective.
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Second, the Fed’s growing involvement is ultimately inconsistent with the proper efficient functioning of a market economy. With a market share that will end 2013 between 30% and 45% depending on the securities, the Fed is heavily involved in markets as both a referee and player. As such, it distorts their functioning, the price discovery process and the allocation of capital.
Third, all this threatens the institutional credibility and legitimacy of the Fed. It also exposes it to greater political interference and will anger America’s friends and allies abroad.
This is not necessarily to say that the Fed should have refrained from doing what it did. Instead, it should be read as yet another very loud and clear message to our bickering politicians. Washington should not fool itself into thinking that the Fed can maintain for long a wedge between Congress’ responsibilities and the economic wellbeing of the nation.
Even if it is willing to venture ever deeper into experimental mode — and clearly it is — the central bank is hard-pressed to deliver good and sustainable economic outcomes. The best it can do is buy time for our politicians who continuously fail to compromise and to reach agreement on a way forward.
Let us hope that this new Fed window will be used well by Washington, and that Congress will finally step up to its economic management responsibilities. If this does not materialize, the economy could risk ending up in a worse place: failing to generate high growth and job creation, further hampered by market distortions and inefficient capital allocations, and having damaged the credibility, legitimacy and future effectiveness of the Fed.
