The Fed experiments with imperfect tools

Financial Times

The writer is the chief executive and co-chief investment officer of Pimco

Policy experimentation continues unabated in the US with the Federal Reserve launching on Wednesday a new initiative to influence market valuations and, through this, the outlook for the country’s economy. The Fed hopes to use greater transparency to mould expectations in a manner that promotes economic growth and price stability. But this new approach could also create confusion and even greater hesitancy on the part of healthy balance sheets to engage in productive investments.I suspect the Fed recognises that the policies at its disposal are a long way from ideal. Interest rates are already floored at zero and, according to the latest statement, will likely stay there at least through the end of 2014. Meanwhile, its balance sheet has ballooned to a previously-unthinkable 20 per cent of gross domestic product ($3,000bn) through direct purchases of securities in the market place. It is also “twisting”, as holdings of shorter maturity Treasuries are replaced by longer-dated ones.

This unusual policy activism has helped prevent a damaging deflationary spiral. But it has not been sufficient to restore America on the path of sustainable growth and sufficient job creation, nor will it. As acknowledged by Ben Bernanke, the Fed chairman, the benefits have come with “costs and risks”. Moreover, despite its repeated pleas for fiscal and housing engagement, the Fed has inadvertently provided cover for other government agencies to continue avoiding difficult, but necessary, decisions.

Notwithstanding these shortfalls, the Fed still feels compelled to do even more. For both moral and political reasons, it believes that it cannot be seen to stand on the sideline as the economy struggles with a deeply-entrenched unemployment crisis and political dysfunctionality – even if this means having to use even more imperfect, indirect and, increasingly, unpredictable policy measures.

On Wednesday, the Fed showed how it intends to use “communication” as a much more active tool to inform and influence economic outcomes. But this approach goes well beyond the concept of greater transparency. By publishing members’ individual forecasts – specifically, the annual evolution of the policy rate, the timing of the first hike and a long-term natural rate – the Federal Open Market Committee wants to provide a firmer and steadier outlook to encourage investors, in both physical and financial assets, to commit to long-term decisions.

Few expect this new initiative to have an immediate or durable impact. Beyond 2012, individual FOMC members’ forecasts are quite dispersed, including a 0.25 per cent to 2.75 per cent range for the target Federal Funds rate for end 2014. It will also take time for households, companies and investors to digest yet another set of signals. Moreover, they are much more interested in the likelihood of a new round of Fed purchases, QE3, than forecasts that deal with an unusually uncertain future and are likely to change frequently.

This latest Fed initiative would need to meet two conditions to be effective in the longer-term. We need to see a significant clustering of FOMC member forecasts that could credibly translate into a medium-term vision for policy rates, and greater responsiveness on the part of households, companies and investors to price movements. But even these will not prove sufficient unless the Fed’s continued activism is part of a more comprehensive policy response out of Washington. As yet, there is little to suggest that we are moving quickly enough to meet this requirement.


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