Barry Eichengreen, Taper in a teapot: The Fed’s tweaking of monetary policy

The decision by the US Federal Reserve to reduce the rate of its securities purchases by $10bn a month is best dismissed as
a taper in a teapot. It is much sound and fury signalling little.
In effect, the Fed tightened current monetary policy almost indiscernibly, while at the same time using forward guidance – that is, this month’s statement by the Federal Open Market Committee – to indicate that future policy would remain loose for at least slightly longer than previously anticipated.
This was a sensible way of tweaking the time profile of monetary policy. The US economy has been doing a little better than expected of late, and therefore is now able to digest this slightly tighter policy.
At the same time, serious concerns remain about America’s medium-term economic prospects. There is uncertainty about whether the pace of recovery will continue to disappoint. There is the question of whether and when the alarming decline in labour force participation, which has created the appearance but not the reality of lower unemployment, will be reversed. Given these uncertainties, it is entirely appropriate for the Fed to signal that it may be even more supportive of the economy in the medium term.
But these changes are inconsequential by the standards of the dramatic and unprecedented developments in monetary policy that we have seen since the crisis of 2008; $10bn of monthly securities purchases are a drop in the bucket for a central bank with a $4tn balance sheet. Even if this $10bn reduction is the first in a series of steps in the same direction, it will take many months before the change has a discernible impact on the Fed’s financial statement.
Wall Street may have had trouble figuring this out on Wednesday afternoon, when the Fed’s statement seemingly threw the financial markets into a tizzy. But, having slept on it, stock traders should be able to recognise the Fed’s announcement for the non-event that it is.
The one consistent impact of the FOMC announcement was on the dollar exchange rate, which rose sharply against the yen and other currencies. This should not come as a surprise. Even a slightly tighter Fed policy now makes for a significantly stronger dollar, since monetary tightening will not only strengthen a currency but cause it to overshoot its new equilibrium value, other prices being slower to move. Thus, we should expect to see the dollar give back some of the ground it gained in coming days. The rise in the dollar will turn out to be another tempest in a teapot.
In contrast to the effect of Fed chairman Ben Bernanke’s “tapering talk” in May, which led to a very sharp emerging market correction, the FOMC announcement is unlikely to have much impact on these countries. For one thing, investors this time are better prepared. They may not have been certain that tapering was coming this week but neither were they as surprised as they were by Mr Bernanke’s earlier statements.
For another, emerging markets are better prepared. Their exchange rates and stock markets are not as overvalued as they were in May. Their financial markets are not as dependent on foreign money. They are, therefore, not as vulnerable to correcting downwards.
Finally, policy makers in emerging markets have already gone one round with the Fed. If they gained anything from their less than happy experience last summer, they at least learnt what kinds of response are more likely and less likely to reassure the markets.
The value of this week’s decision is mainly symbolic. It is a way for the Fed to signal to its detractors that it hears their criticisms of its unconventional monetary policies, and that it shares their desire to return to business as usual. The decision beats back some of the criticism to which the Fed is subject, and diminishes prospective threats to its independence. But, at the same time, the central bank has also signalled that it is not prepared to return to normal monetary policy until a normal economy has returned. As Hippocrates might have said, it has at least done no harm.

Barry Eichengreen is professor of economics and political science at the University of California, Berkeley


Fonte: FT