The Fed's empty toolbox

Two distinguished Wall Street names have expressed concern about the current state of Federal Reserve policy as the promised taper gets pushed out until at least 2014.

While much of the focus at this week’s Buttonwood Gathering in New York was on the gradual improvement in the global economy, the exit strategy of the US Federal Reserve from its highly experimental quantitative easing program shone through as the greatest fear.

According to PIMCO chief executive Mohamed El-Erian, the Fed should have started its taper last month.

“I was shocked they didn’t taper in September,” he informed delegates at the annual conference. “Having conditioned the market, the door was wide open and they would have gained a bit of optionality, which I think is very important going forward.”

El-Erian’s state of disbelief was shared by Morgan Stanley chief economist Vincent Reinhart, who couldn’t marry the Fed’s actions with its words.

“I was quite surprised, mainly because I listened to what they had said,” he explained. “I still don’t understand why they didn’t actually execute.”

The exit strategy of the Fed has been the topic of much conversation as the planned September move has now been shifted to an unknown date (A tough job for the Fed in 2014, October 31).

Still, Reinhart is hopeful US central bankers will soon realise the risks of QE now outweigh the benefits.

“When they walk away from QE it’s not because they think the economy needs less accommodation, it’s that they believe they can provide it more effectively via the rate channel,” he said. “(Therefore) I don’t think they’re going to need much of a pick-up in GDP to convince themselves that it’s time to begin the process of monetary normalisation.”

El-Erian agrees, suggesting that we are trekking toward “a very gradual period from QE to more aggressive forward (rate) guidance.”

The Morgan Stanley economist and the PIMCO exec see eye-to-eye in approving the Fed’s role in dragging the US economy from the brink, but both wonder about the power of the tools left in the locker.

“If you drew up a list of the 15 things that could be done in Washington DC to help sustain economic expansion, I’m pretty sure forward guidance would be about number 13, QE would be 15,” Reinhart warned. “The problem is 1 through 12 is not on the table because the political system is polarised.”

The Fed “simply doesn’t have the right tools for what is required,” El-Erian added, making the five-year outlook rather cloudy.

“I’m more nervous than I was a year ago. In the last year. … Whenever (the West) has come to make a consequential decision the reaction has been to kick the can down the road. So a year later we’re still stuck in this new normal of low growth equilibrium and high unemployment and rising inequality. We still don’t have clarity on some major issues and the Fed has had to experiment more.”

Adding to the mixed outlook for the taper is the imminent change of Fed leadership, with uber-dove Janet Yellen to take the reins at one of the more crucial junctures in the central bank’s history. Reinhart argues that Yellen has a “wonderful opportunity” to make it clear price stability will be a hallmark of her reign, but nonetheless doesn’t expect her dovish nature to change.

“She will keep policy accommodative for a very long time,” he confided. “Lower for longer.”

Yellen is a big believer in forward guidance, but Reinhart questioned its usefulness while it lacks a believable narrative.

“The key problem is forward guidance works if you are laying out a credible plan and right now their problem is that the path for rates … doesn’t seem plausible to me,” he concluded, making the case that rate moves in past recoveries have rarely been as gradual as what’s currently proposed.

Incumbent Ben Bernanke may have confronted once-in-a-generation challenges during his time as Federal Reserve chief, but it looks like his successor’s reign will be scarcely much easier.