Through both its actions and what it refrained from doing, the Federal Reserve has confirmed that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.
To grasp the Fed’s policy dilemma, we must first discuss the why and what of additional unconventional Fed measures.
Three realities anchor the case for additional measures, notwithstanding the fact that the results of prior policy intervention actions have consistently fallen short of policymakers’ own expectations.
First, the FOMC reiterated concerns about the country’s economic prospects, and rightly so. It echoed chairman Ben Bernanke’s speech at Jackson Hole on August 31. There he cited America’s "daunting economic challenges,” including the "grave concern” of a stagnant labour market where high unemployment – even if predominantly cyclical in nature as Bernanke believes – would get embedded in the structure of the economy were it to persist for long.
Such worries were accentuated in the last week by the disappointing August employment report, as well as the more recent high frequency jobless claim data released earlier on Thursday. Both confirm weak job dynamics. They come at a time when long-term and youth unemployment is way too high, Americans are dropping out of the labour force, poverty is on the rise, and income inequality is widening.
Second, the Fed is not helped by the fact that it is the only entity properly engaged in addressing America’s challenges. Others, including those paralysed by deep congressional splits, are standing on the sidelines even though they have better suited policy instruments.
Then there are the unusual "tail risks” facing the economy and additional policy insurance they appear to warrant – from the threat of the European debt crisis to the self-inflicted fiscal cliff in the US and mounting political risks in the Middle East. If even one were to materialise, America would soon find itself again in a recession which would accentuate economic, financial, political and social fragilities.
With this in mind, Fed officials decided to experiment even more. They extended forward guidance, stating that policy rates are expected to stay exceptionally low "at least through mid-2015”. Importantly, they also committed to additional, open-ended purchases of mortgage-backed securities (what will likely be labelled "QE3”).
History and detailed analyses of the problems underpinning America’s prolonged economic malaise suggest that these well-intentioned measures will again fail to secure a much better economic situation. This is also behind the widening gap between economists urging the Fed to do even more and those favouring less.
In refraining from going beyond forward guidance and QE3, the Fed is seeking to balance these two competing views. It thus refused to cut the interest it pays on excess reserves despite some arguing that this would induce banks to lend more to the real economy and thus encourage greater economic activity. It also declined to move from an intermediate policy target (boosting asset prices) and time commitment (mid 2015) to specific economic targets (including nominal GDP).
With both options having been discussed by Fed officials, their revealed preference speaks to important considerations that will grow in the months ahead.
They signalled growing recognition of the "costs and risks” of unconventional policies – from undermining the functioning of certain market mechanisms to hampering entire segments that provide financial services to citizens (such as money market accounts, life insurance products and pension coverage). For example, a cut in the IOER would have dealt an even bigger blow to the money market industry. They also reinforced Bernanke’s earlier view that "monetary policy cannot by itself [deliver] what a broader and more balanced set of economic policies might achieve.”
Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire – high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together. Until this happens, the Fed will remain in policy purgatory.
Copyright the Financial Times 2012.