The Fed’s Surprise and Yellen’s Challenge

Portrait of Mohamed A. El-Erian 

Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $2 trillion in assets under management. He previously worked at the Internation…

The Fed’s Surprise and Yellen’s Challenge

NEWPORT BEACH – The US Federal Reserve sparked a global – and now month-long – guessing game with its decision on September 18 not to “taper” its monthly purchases of long-term securities. The Fed does not surprise markets often, and this has been especially true of the Ben Bernanke-led Fed, which has devoted enormous time and effort to better communication, greater transparency, and timely management of expectations. Now that President Barack Obama has nominated Fed Vice Chair Janet L. Yellen to succeed Bernanke in January, there is even greater interest in what lies ahead for the world’s most important central bank.

To be sure, Fed officials did not do a great job of managing expectations in the weeks preceding their September policy meeting. Having also struggled to reclaim the narrative thereafter, there is great interest in understanding what led the Fed to act in such an uncharacteristic manner. Nonetheless, the real issue is that the Fed’s last-minute change of heart does not significantly alter the main challenge that the highly qualified Yellen will face: persistently weak economic fundamentals and doubts about the continued effectiveness of the Fed’s policy tools.

Five main arguments for the Fed’s decision to postpone the taper have frequently been proposed. One view is that the Fed recognized that its specification of policy thresholds (based on the unemployment rate) understated the vulnerability of the US labor market. Another is that officials worried about excessive financial tightening after Bernanke’s mention in May of a possible taper, jeopardizing the economy’s gradual recovery.

Moreover, some believe that the Fed considered the possibility of adverse feedback loops associated with the financial dislocations in emerging economies. Others see in the decision to postpone the taper an effort to pre-empt the negative effects on the economy of a possible congressional debacle over government funding and the debt limit. Indeed, the final argument – in a sense underpinning the others – is that the Fed became less worried about the potential for collateral economic damage from prolonged reliance on unconventional monetary policy.

The first three arguments speak to the Fed’s heightened concerns about the economy in general, and about the labor and housing markets in particular. The fourth reflects a desire to insure the economy against congressional dysfunction. And if the Fed feels that the costs and risks of hyper-activism have indeed diminished (the fifth argument), it becomes more comfortable maintaining intense policy experimentation.

Most of these arguments – though not all of them – have merit. That is the good news. The bad news is that the decision not to taper is unlikely to put either the Fed or the economy in a better place, confronting Yellen with a difficult task when she begins her historic tenure.

True, the Fed’s use of the classic measure of the unemployment rate as a key policy threshold underestimates the US economy’s fragility. Rather than reflecting buoyant job creation, too much of the recent decline in the unemployment rate has been associated with a fall in labor-force participation to a level last seen 35 years ago. Long-term joblessness and youth unemployment remain far too high, with skills erosion, reduced mobility, and a growing opportunity gap relative to formal educational attainment risking lasting damage in the aftermath of the Great Recession.

The debate about financial conditions is both more heated and more nuanced. While equity and credit markets did rebound from their May-June dislocation, higher interest rates have hit the housing market quite hard, reflected in a sharp fall in the mortgage-refinance index, lower home affordability, and declining purchases.

This attests to the extent to which parts of the financial intermediation process remain over-reliant on Fed experimentation, even as small and medium-size companies still find it difficult to obtain adequate credit at reasonable cost. The less confident the Fed is about the robustness of economic recovery at home, the greater is its interest in minimizing external headwinds.

Thus, it would be natural for the Fed to worry about slowing economic growth in emerging countries (accentuated in countries like Brazil and India by the financial volatility that followed the Fed’s taper talk in May). Moreover, with extreme political partisanship causing a government shutdown and threatening a debt-ceiling debacle, it would be understandable for the Fed to try to limit the impact of a dysfunctional Congress on consumer demand and business confidence.

So what does all this say about the future, including the key issues facing Yellen?

In assessing how far it is from meeting its mandate, the Fed may be better served by shifting from unemployment to employment thresholds (for example, the employment/population ratio). It could even start moving to a more holistic operational measure (say, nominal GDP), together with indicators of the economy’s structural fragility.

The Fed would have an opportunity to discuss this in its upcoming policy meetings in the context of evolutionary steps to strengthen its forward policy guidance, an initiative that Yellen has spearheaded. It may also need to think more about support for small and medium-size firms that continue to face structurally clogged credit pipes.

Unfortunately, with what is happening in Washington, none of this would significantly heighten the durable impact of Fed policy on economic growth and employment. Other policymaking entities – particularly those with potentially more effective tools to help the economy reach escape velocity – need to act but are hampered by legislative impasse. Meanwhile, continued and prolonged reliance on unconventional policies does involve unusual uncertainty and potential costs.

With Yellen’s nomination to succeed Bernanke, one Fed guessing game has ended. But, as speculation over the direction of monetary policy continues – indeed, intensifies ahead of the Fed’s next policy meetings – we should not lose sight of an uncomfortable reality: No matter how hard it tries – and it is trying very hard – the Fed is still stuck with tools that are too blunt, and whose effects are too indirect, for the challenging tasks at hand.

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