The Fed’s fudge is an ambiguous bequest to Yellen

At 1.40pm on Wednesday, US Federal Reserve officials locked the door on a room full of journalists, pulled the plug on the internet and announced that they would now distribute two statements: the usual one from the Federal Open Market Committee and an extra release from the markets desk of the New York Fed.
It prompted an ironic cheer and a smattering of applause around the room because the second statement could mean only one thing: the long-awaited, much-debated, market-shaking taper of the Fed’s $85bn-a-month in asset purchases had finally arrived. When the news went out 20 minutes later, markets cheered as well. The S&P 500 ended the day at a record closing high – a positive reaction that pretty much nobody had anticipated would greet lower monetary stimulus.
It was one of those seemingly dull and utilitarian Christmas presents, like a new briefcase, that turns out to make a big difference to your life. After more than six months of speculation, market gyrations and bad puns (a tapir, I now know, is a browsing mammal that looks like a pig with a long nose), the Fed had made its move. Traders can come back in January and think about something new. Relief from the tension is as good an explanation for the rally as anything.
The decision to taper purchases to $75bn a month means that Ben Bernanke, the Fed chairman, will depart in January having taken the first step back from aggressive monetary easing. It makes for an elegant ending to his eight years in office. While the direct effect of the taper is minimal – rates are still zero and $75bn is a lot of assets to buy every month – it marks the moment of “peak stimulus”, the point at which the Fed declares it no longer needs to do ever more to help the recovery.
But the taper does not mean the Fed can now sit back comfortably or that Mr Bernanke has left his successor, Janet Yellen, with an easy hand to play. The Fed has fudged its communications in a way that looks vulnerable to future shocks. That will be especially true if, as is quite likely, 2014 brings the first scare for a while about overly rapid growth.
Yesterday brought an upward revision in the annualised pace of US growth to 4.1 per cent for the third quarter of 2013. Most data on the fourth quarter suggest the underlying pace of growth has accelerated. With little drag from fiscal policy, households in a position to borrow again and better economic numbers around the world, the odds favour strong growth in the US next year.
The problem for the Fed is that a run of good news may lead markets to reject its forecast that interest rates will not rise until well into 2015, and only slowly after that. If market interest rates start to rise, that will slow the economy, and the Fed has weakened the communication tools it could use to push back.
For example, the Fed’s 6.5 per cent unemployment rate threshold, above which it will not raise interest rates, is now in effect defunct. Rather than lower that number, the Fed said it expects to keep rates low “well past the time that the unemployment rate declines below 6.5 per cent”, but a vague form of words such as this is much easier for markets to test and disregard than a concrete figure.
The Bank of England ran into similar trouble with its own 7 per cent threshold this week, when the unemployment rate suddenly fell to 7.4 per cent, prompting talk of rate rises. Thresholds have turned out to be very convincing – markets trust central banks when they set a number – but the flaws of the unemployment rate as a measure of economic health have undermined them in practice.
The path for asset purchases that Mr Bernanke laid out will also pose some problems if the Fed needs to respond to a stronger or weaker economy. Although the chairman insists the Fed’s bond-buying is not on a “preset course”, he says the basic plan is for a small taper at every meeting from now on, bringing purchases down to zero towards the end of next year. That is like getting into a car and programming a destination into the satnav. If the economy weakens, the Fed might stop for a sandwich along the way – so its course is not exactly preset. But nor is there much doubt about where it is going.
As with the softening of forward guidance, the effect of this is to make the Fed less intimidating, and so more vulnerable if markets test its desire to keep rates down. Before the taper, asset purchases were open-ended, so markets had to worry they would go on for ever. By contrast, “we’re going to delay the next taper for a month!” is not the kind of threat that traders will be scared to bet against.
It is likely, therefore, that at some point during her first year in office Ms Yellen will face a moment when market interest rates are higher than she wants or believes to be justified. If that moment arrives, it will have repercussions around the world, with a stronger dollar that sucks capital out of the most vulnerable emerging markets.
Ms Yellen will have to find a way to respond – and the Fed’s toolbox is not empty yet. She could toughen up its forward guidance again, perhaps setting a minimum level of inflation before rates can rise, or even going back to a calendar date. She could cut the interest paid on bank reserves. The Fed could even use asset purchases directly to target some market interest rates if they move too far out of line.
The economy is looking better and the taper has arrived, but this is not the end of excitement from the Fed, and may not be the end of actions to ease monetary policy. For Ms Yellen, new challenges await.

Robin Harding

Fonte: FT