Judging from signals out of the Federal Reserve, this week may well mark the first stage of its tricky multi-year policy pivot away from unconventional monetary policy. The central bank’s key objective is to maintain adequate support for a still-sluggish economy while reducing its dependence on distortion-threatening measures. The implications of this new stage of the Fed’s highly-experimental monetary policy are both uncertain and consequential, not only for the U.S. but also for the rest of the world.
While the healing process steadily continues, the U.S. economy is yet to show signs of emerging decisively from a multi-year low-level growth equilibrium that frustrates job creation, worsens income distribution and contributes to political polarization. Indeed, if anything, Fed officials will likely be forced this week to again lower their growth projection — a depressingly familiar routine since the onset of the global financial crisis.
Yet the Fed is on the verge of reducing its exceptional support for the economy, and not because it is in a position to declare victory. Instead, it is a recognition that, as stated by Chairman Ben Bernanke back in August 2010, unconventional policy stance entails not just “benefits,” but also “costs and risks.”
Judging from their remarks, central bank officials are particularly concerned that their prolonged artificial support of asset prices fuels excessive risk-taking, resource mis-allocations and market malfunctions. As such, the first step of their new policy pivot this week will likely involve a “taper” of the $85 billion in monthly purchases of market securities — one of the three exceptional measures deployed to promote adequate employment (the other two being a floored fed funds rate for an exceptionally long period of time, and aggressive forward-policy guidance).
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In initiating the taper, the Fed will inevitably confront tricky decisions on size, composition and sequence.
Given the realities of the tepid economy and the range of policy uncertainties (including for other countries, especially in the emerging world), the Fed would be well advised to start small – e.g., a $10-$15 billion reduction in monthly purchases. It would be best if the reduction falls disproportionately on U.S. Treasuries, thus favoring for now the purchase of MBS (mortgage-backed securities) to support a housing market that is already showing some early signs of weakening. And, rather than announce a detailed forward schedule for additional taper, the Fed would need to retain considerable flexibility for timely mid-course corrections.
Unfortunately, as the Fed starts to lift its foot off the accelerator, it cannot expect much support from other policy-making entities (even though they possess tools better suited to address many of America’s remaining economic problems). As such, the central bank would also need to tweak this week its own policy mix to minimize the risks to the economy and jittery markets.
Look for the Fed to evolve its forward policy guidance in an attempt to anchor the front end of the yield curve, repress interest rate volatility, and reduce the risk of taper-induced disorderly increases in intermediate and long rates.
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Naturally, the temptation would be to craft clever words that appropriately impact the private sector’s behavior. But, as the recent Bank of England experience shows, simple words struggle in persuading when a central bank is also relying less on asset purchases. And it won’t help that the Fed is fast approaching a major change in the composition of its policy-making Committee (the FOMC) and, even more importantly, a change in top leadership.
If they wish to reduce the risk to the domestic (and global) economy of interest rate instability, Fed officials will likely be looking at the following options to further pre-commit in the eyes of the private sector their future policy stance: return to calendar guidance (highly unlikely now that they have shifted to thresholds), lower the unemployment threshold from the current 6.5% (unlikely but more possible), shift to nominal GDP targeting (possible though not at this time) or insert an inflation floor (say 1.5% — highly possible though controversial).
None of this is easy or straightforward. Nor is it possible to predict with accuracy the impact on financial conditions and the real economy. What is certain is that the Fed is embarking on yet another policy voyage laden with uncertainty and some mid-course corrections.
As they gather in their conference room this week, Fed officials will have no tested playbook to use, analytical models to rely on, or historical experiences to draw on. Instead, they will be resorting to sound judgment, open mindsets and good luck. They will also need to ensure that they have in place a myriad of ways to monitor and respond to unexpected developments (both domestic and external), thus requiring an even wider set of data inputs than that mandated by a narrow interpretation of the institution’s mandate.
Mohamed A. El-Erian is the CEO and co-chief investment officer of PIMCO.
