On Sept 17 and 18, the members of the U.S. Federal Reserve’s Open Markets Committee (FOMC) — the U.S. central banks’ key policymakers — will find themselves between the proverbial rock and a hard place. Arriving there has been inevitable ever since March when the Fed started suggesting that the time was approaching to wind down its asset-buying program that has underpinned the U.S. economy’s recovery and financial markets.
There are two related questions it has to answer: whether the economy is now robust enough to take on a “tapering” of stimulus, and at what pace should the $85-billion-a-month asset buying program be wound down.
The Fed has publicly framed the decision in terms of unemployment rates and inflation expectations. Those are broadly enough on track for tapering to begin. But the economy’s overall recovery has shown repeated patches of weakness. They are not sufficiently widespread to undermine the Fed’s baseline assessment of the economy’s improving prospects, but, equally, not sufficiently isolated to confirm it beyond doubt. To complicate matters further, now there is the possible impact of heightened fighting in Syria and beyond (rattled investors, higher oil prices), and a renewal of the political hostilities in Washington over the U.S. government’s budget and debt ceiling (irritated investors, higher economic uncertainty).
If we assume that Fed policymakers will come down in favor of starting to taper (likely, though not certain) and that that the pace of this tapering initially will be $5 billion dollars a month (an even more tentative assumption), we find ourselves staring down a second set of tactical questions, these dealing with how to convince investors that scaling back on bond buying is a different exercise in monetary policymaking than formally raising interest rates. Fed officials have been at pains to stress that their benchmark rates will remain at their current near-zero levels for some time, though they have had difficulty getting that message across to skittish investors in volatile markets.
Few disagree that raising interest rates would be anything but premature tightening. Real-world rates have already risen since May. The 10-year Treasury bond yields 3% now, up from less than 2% then. That has slowed the housing market recovery, but doesn’t seem yet to have spilled over into other areas of domestic economic activity for all it has sideswiped emerging markets and their currencies.
Yet so skittish are investors and so volatile are markets at present that whatever the Fed’s policymakers decide this week, how they word their decision at the end of their two-day meeting will be critical. The forward guidance from the FOMC will be all, on both when rates will eventually rise, and how fast when they do. The credibility challenge is only the greater since many members of the FOMC now promising not to raise rates will be gone by when the time to do so arrives — and not just the chairman, Ben Bernanke, who is due to retire at the end of his term in January.
Tapering is not without risk, as Bernanke will be aware as an academic authority on central banking in the Great Depression. In 1936, the Fed started to tighten policy (in that case via a two-step doubling of the banks’ required reserve ratio) in response to the anticipation of inflationary problems at a time of near-zero interest rates and excessive reserve balances being kept at the Fed (sound familiar?). In conjunction with a tightening of fiscal policy, that led to industrial production declining and the U.S. economy falling back into recession in 1937-1938.
Bernanke is also a student of Japanese recessions. He will know that the series of monetary tightenings in the 1990s after the collapse of that country’s late-80s real estate and stock market bubbles led to a decade of sub-par growth until the Bank of Japan embarked on renewed quantitative easing in 2001 and an even bigger round last year. (The Federal Reserve Bank of San Francisco addressed the question of whether quantitative easing by the Bank of Japan worked in a 2006 paper of the same name; its point about QE delaying structural reform at the banks is particularly germane.)
Tapering is not necessarily tightening; a refrain likely to be heard repeatedly in the coming days from policymakers. The Fed thinks its iteration of QE and the unorthodox monetary policy that has come to define the aftermath of the 2008 financial crisis have worked. It is now time to start returning to conventional policymaking even though the improvement in the U.S. economy remains fragile with unemployment still high and the growth outlook uncertain. Though its first step back towards normal will likely be purely symbolic, the FOMC will want to get away from being between a rock and a hard place as soon as it can.