Fed Course Change: 'Soft Landing' as Chimera
Published in Neue Zürcher Zeitung
(Switzerland) on 20 March 2014
by Christoph Eisenring (link to
original)
The Federal Reserve’s most recent press release runs almost 900 words. Before the financial crisis, decisions on monetary policy were consistently communicated in a concise 200 words. The Fed’s balance sheet has also increased nearly five-fold in comparison to 2007 as a result of its purchases of government bonds and mortgage securities. Not only do these purchases keep long-term interest rates low, they should also stimulate the economy since the (short-term) prime rate has remained near 0 percent for over five years. In any event, the Fed is a long way from normalizing monetary policy, whereby normal would mean two things: First, the end of interventions in the financial markets via bond purchases. Central banks have taken a very interventionist course since the crisis began. What’s needed, instead, is a return to restraint and working in the background. Second, the Fed should once again focus on areas over which it has direct control, namely, maintaining a stable financial system and stable prices. This is still the best service to economic growth that a central bank can render.
Where the Fed Is Heading in the Right Direction
Where is the Fed headed under its new chief, Janet Yellen? The bond purchases will be cut back gradually. All signs indicate that the Fed will terminate the third asset purchasing program in the fall. At that point, its balance sheet may total some $4.4 billion. Initially the Fed justified the bond purchases on the grounds that only the central bank was able to supply the markets with money in an emergency situation. This is undoubtedly correct and has prevented worse economic conditions from developing. Still, the benefits of the second and third asset purchasing programs remain highly contested among economists. In the meantime, Fed Chief Yellen herself has come to the conclusion that the bond purchases have fulfilled their purpose. It must have been quite an extraordinary storm looming for the Fed to have stepped up its purchases again. With the bond purchases, the central bank – while extremely tentatively – had struck a path toward normalization. However, the Fed’s severely bloated balance sheet – inherited from Yellen’s immediate predecessor, Ben Bernanke – makes the program’s phase-out extremely challenging. The Fed must prevent the $2.7 billion currently parked there from suddenly finding its way into the economy and having an inflationary effect.
Moving in the right direction on Wednesday, the Fed also introduced a change to its forward guidance, summarily dropping its jobless rate threshold: Since December 2012, the Fed has repeatedly avowed to raise the prime rate only after the unemployment rate had fallen under 6.5 percent. Unemployment currently stands at 6.7 percent. It fell unexpectedly fast, in part because many Americans have stopped looking for work. This simply illustrates that monetary policy alone has barely any influence over the unemployment rate in the short term – the situation is fundamentally different over the longer term because factors like regulation, education, fiscal policy or technological development play crucial roles. A central bank can only contribute to full employment indirectly by providing for stable prices and stable financial markets. This has at times been forgotten in the U.S. in recent years.
Promise of Lower Rates as a Wrong Signal
As was its prior practice, the Fed now wants to consult a variety of sources over the labor market and inflation before it decides to raise the prime rate. Had the Fed stopped here on Wednesday, one might be able to speak confidently of another step toward a traditional fiscal policy. However, the press release goes on at length to state the open market committee’s explicit desire to keep the prime rate low for longer than usual, even in a situation where inflation and the unemployment rate were to return to close to normal levels.
No one can have anything against a low prime rate for now, as inflationary pressure is low and at 1.2 percent, inflation sits below the target rate of 2 percent. But it’s risky to effectively promise that the real interest rate (prime rate minus inflation) will still be extremely low at the end of 2016. The phase-out of the Fed’s very lax monetary policy may be much more difficult and unpredictable than in normal times. The Fed aims for an initial rate increase in mid-2015, leading thereafter to a slow normalization, or "soft landing" for the economy. But whoever believes in such fine-tuning of the economy trusts too much in fiscal policy. The last crisis taught a different lesson: One cause of the crisis was precisely that monetary policy had held the prime rate too low for too long. What is intended as a "soft landing" could lead to a crash landing when monetary authorities are slow to apply the brakes.
Where the Fed Is Heading in the Right Direction
Where is the Fed headed under its new chief, Janet Yellen? The bond purchases will be cut back gradually. All signs indicate that the Fed will terminate the third asset purchasing program in the fall. At that point, its balance sheet may total some $4.4 billion. Initially the Fed justified the bond purchases on the grounds that only the central bank was able to supply the markets with money in an emergency situation. This is undoubtedly correct and has prevented worse economic conditions from developing. Still, the benefits of the second and third asset purchasing programs remain highly contested among economists. In the meantime, Fed Chief Yellen herself has come to the conclusion that the bond purchases have fulfilled their purpose. It must have been quite an extraordinary storm looming for the Fed to have stepped up its purchases again. With the bond purchases, the central bank – while extremely tentatively – had struck a path toward normalization. However, the Fed’s severely bloated balance sheet – inherited from Yellen’s immediate predecessor, Ben Bernanke – makes the program’s phase-out extremely challenging. The Fed must prevent the $2.7 billion currently parked there from suddenly finding its way into the economy and having an inflationary effect.
Moving in the right direction on Wednesday, the Fed also introduced a change to its forward guidance, summarily dropping its jobless rate threshold: Since December 2012, the Fed has repeatedly avowed to raise the prime rate only after the unemployment rate had fallen under 6.5 percent. Unemployment currently stands at 6.7 percent. It fell unexpectedly fast, in part because many Americans have stopped looking for work. This simply illustrates that monetary policy alone has barely any influence over the unemployment rate in the short term – the situation is fundamentally different over the longer term because factors like regulation, education, fiscal policy or technological development play crucial roles. A central bank can only contribute to full employment indirectly by providing for stable prices and stable financial markets. This has at times been forgotten in the U.S. in recent years.
Promise of Lower Rates as a Wrong Signal
As was its prior practice, the Fed now wants to consult a variety of sources over the labor market and inflation before it decides to raise the prime rate. Had the Fed stopped here on Wednesday, one might be able to speak confidently of another step toward a traditional fiscal policy. However, the press release goes on at length to state the open market committee’s explicit desire to keep the prime rate low for longer than usual, even in a situation where inflation and the unemployment rate were to return to close to normal levels.
No one can have anything against a low prime rate for now, as inflationary pressure is low and at 1.2 percent, inflation sits below the target rate of 2 percent. But it’s risky to effectively promise that the real interest rate (prime rate minus inflation) will still be extremely low at the end of 2016. The phase-out of the Fed’s very lax monetary policy may be much more difficult and unpredictable than in normal times. The Fed aims for an initial rate increase in mid-2015, leading thereafter to a slow normalization, or "soft landing" for the economy. But whoever believes in such fine-tuning of the economy trusts too much in fiscal policy. The last crisis taught a different lesson: One cause of the crisis was precisely that monetary policy had held the prime rate too low for too long. What is intended as a "soft landing" could lead to a crash landing when monetary authorities are slow to apply the brakes.
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