Expect more of the same active inertia from the Fed

It will be instructive to compare this Wednesday’s policy announcements from the Federal Reserve with the gradual tapering and forward policy guidance many analysts and commentators forecast just a few weeks ago. I suspect the US central bank will appear to be stuck with the same mix of policy tools even though growth outcomes have consistently fallen short of their expectations. And while recent congressional dysfunction has reduced its room for manoeuvre in the short term, there are deeper forces at play that blunt America’s job recovery, with implications that extend well beyond the Fed.
At the conclusion of their two-day policy meeting, Fed officials are likely to announce few if any changes to the big three components of their current policy stance: floored policy rates will not be touched; forward guidance language will not evolve much; and balance sheet purchases will remain as is, at $85bn a month (also with no change in composition).
Just a few months ago, most analysts expected that, by now, the Fed would be engaged in an important policy pivot involving a gradual taper in purchases and greater reliance on forward policy guidance. Such a pivot was deemed important to strike a more sustainable balance between, to use Fed chairman Ben Bernanke’s phrase, “the benefits, costs and risks” of prolonged reliance on unconventional monetary policy.
A less upbeat assessment of the US economy by the Fed will shed some light on why officials are not altering their policy stance. Partly due to the most recent Congressional debacle – namely, shutting down the government for 16 days, waiting until late in the day to raise the federal debt ceiling and, rather than resolve these issues decisively, postponing them to the first quarter of next year – the Fed is likely to again revise down its projections for economic growth.
Blaming Congress would be the easy way for officials to explain why the Fed retains a policy stance that delivers less than expected. It would also be comforting as it would place the blame elsewhere, thus suggesting a lower degree of internal policy difficulties.
Yet growth downgrades have become depressingly frequent. They occurred in each of the past five years; and it is highly probable that the Fed will do so again for what remains of this year. In the process, officials will be signalling recurrent frustration with two factors.
They have repeatedly discovered that the institution’s ability to promote economic growth and create jobs is weaker than what was anticipated and is needed. This was true for quantitative easing 2 and Operation Twist; it is now also the case for QE3.
They also know that signals to alter the course of policy can easily end up by, excessively and pre-emptively, tightening financial conditions and undermining growth and jobs. Just witness what happened between May and June when the mere mention of a taper disrupted the functioning of financial markets and pulled the rug under housing.
The result of all this goes beyond the shackles of a low-level growth equilibrium, persistent unemployment that risks getting more deeply embedded in the structure of the economy, and high and rising inequality. It also speaks to an increasingly unhealthy co-dependency between the Fed and financial markets.
Markets are now consequentially reliant on continued Fed accommodation, and this regardless of its impact on the real economy and top-line corporate revenue growth. And since unfortunately the Fed is essentially the only policy making entity working hard to promote employment, it ends up seemingly hostage to these markets given that they are such a critical component in the policy transmission mechanism.
The Fed is unable (some would – less charitably – say unwilling) to move either decisively forward or resolutely back. Instead, it appears mired in a classic state of active inertia. This is unlikely to change any time soon.
Despite its considerable operational autonomy and relative political independence, the Fed will remain constrained to a highly gradualist approach that is increasingly ineffective. Moreover, the solution to its policy dilemma will continue to migrate out of its hands and to other policy making entities that already find themselves sidelined by congressional polarisation.
The key issue facing the Fed – indeed, this is true for the US as a whole, Europe, Japan and, by implications, the global economy – boils down to the urgent need to invigorate a much broader set of growth and job engines. Absent a more holistic response that involves a lot more than the central bank, policy will languish in the muddled middle. And as the Fed repeatedly struggles virtually on its own to deliver durable growth and medium-term financial stability, other central banks will find that their own policy flexibility is also negatively affected.

Mohamed El-Erian writer is the chief executive and co-chief investment officer of Pimco

Fonte: FT