James Saft, Reuters Columnist
The Fed said on Wednesday it would continue buying bonds at an $85 billion monthly pace for now, citing concerns about a sharp rise in borrowing costs in recent months and the upcoming budget battle in Washington.
This came as a huge surprise to most people, well anyone who listened to and believed what Fed Chairman Ben Bernanke has been saying for the past three months or so, when he did a masterful job of setting the market up for a tapering of bond purchases.
“The tightening of financial conditions observed in recent months, if sustained, could slow the pace of improvement in the economy and labor market,” the U.S. central bank said in a statement explaining its decision.
Seriously, the Fed, having led us to believe it would taper, just told us it wasn’t tapering because we believed them. What, exactly, are we now to think?
I’ve been among those who criticized the Fed for artificially suppressing volatility in financial markets, but I didn’t intend for them to increase it by acting unpredictably;I was hoping more that they’d let assets find their own values.
To be sure, this was the right thing to do. Neither of the Fed’s mandates – controlled inflation or full employment – was anywhere near target. Inflation is too low, as the Fed acknowledged, and though energy prices rise and fall there seems little demand push in the economy which will bring it back towards the Fed’s 2 percent target. The risks are the other way.
And employment too is nothing like in shape to justify a tightening of financial conditions, which is exactly what a taper is. It was good to hear Bernanke say that the unemployment rate, which is hugely flattered by frustrated and aging workers falling out of the count, is not always the best indicator. Good too to hear him nod towards the participation rate, though we may be waiting quite some time for a taper if a normalizing of labor force participation becomes a precondition.
So yes, there was no good economic reason, other than doubts that the risks of QE are greater than the benefits, to taper. And yes, the data which came in over the summer wasn’t fantastic, and yes, people believing the Fed’s communications meant that mortgage rates went higher, which slows the housing recovery.
I get all that, but can’t help but feel that things would be better if the Fed hadn’t floated the taper idea in the first place.
Insuring bad behaviour
One other huge issue is the way in which the Fed tied a direct line between not tapering and the looming budget battle in Washington.
“A government shutdown, and perhaps even more so a failure to raise the debt limit, could have very serious consequences for the financial markets and for the economy, and the Federal Reserve’s policy is to do whatever we can to keep the economy on course. And so if these actions led the economy to slow, then we would have to take that into account, surely.
“So this is one of the risks that we are looking at as we think about policy,”Bernanke said.
His analysis is correct, but really is it the job or the role of the Federal Reserve to provide the country with an insurance policy against the failure of other branches of government to do their jobs? Does this not give legislators and the executive license to go ahead and not get to grips?
If we’ve learned anything in the past 10 years it is that the Fed has only a few tools, and those tools are suited to only a few purposes. I am not sure that the Fed can, or should, smooth out lumps caused by actions in Washington any more than it can, or should, build bridges or collect taxes.
So what happens now?
The Fed may choose to taper later this year, but its opportunities will be limited. There is no press conference in October when the Fed meets, so that leaves the December meeting which is shortly before Bernanke is slated to leave office.
It is possible that the Fed would begin the taper then if, as expected, Janet Yellen is named his successor, which in itself would take a certain amount of volatility out of the transition.
The harder question is will the economy play along. Quantitative easing is proving to be much easier to expand and extend than to stop.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. You can email him at jamessaft@jamessaft.com)