Tuesday, September 24, 2013

The Fed's exit problem

The Fed's decision to continue with its $85 bn a month asset purchases program and thereby put to rest, at least for now, fears of a tapering of its third round of quantitative easing program, is surprising. Clearly, faced with the uncertainty surrounding the strength of US recovery and the effect of any unwinding on the global financial markets, the Fed has blinked. It has preferred to let the status quo continue. A few observations.

1. Given this line of thinking, it is now difficult to see how the Fed will ever, on its own, summon the courage to exit its extraordinary monetary accommodation. This is all the more so since any evidence of recovery is likely to be always mixed. And if there is any conclusive evidence of recovery, then it is most likely that the Fed is behind the curve in exiting. This represented a great opportunity, especially since the financial markets had recovered most of the lost ground.

2. The extended period of monetary accommodation is most certain to have solidified a very strong coalition of vested interests who have benefited from it. Needless to say, the financial industry has been the biggest beneficiaries. It is no surprise that Janet Yellen has got considerable support from the Wall Street despite the uncertainty surrounding her views on banking regulation.

3. The Fed may have become entrapped in a self-fulfilling dynamic. On the one hand the Fed believes that the market conditions demand continued monetary accommodation. However, on the other hand, the financial markets will always react adversely to any news of a tapering, irrespective of the underlying factors. Drug addicts are not likely to react with happiness when denied their dope!

4. The disproportionate focus on cheap credit to enable recovery from the Global Financial Crisis and the Great Recession betrays a cognitively biased view of managing an economic crisis, at least on two counts. One, as more fundamental policy responses are not forthcoming, a false belief develops surrounding the central bank's powers. It becomes very attractive to persist with monetary easing, especially when it is not leading to inflation or crowding-out. Two, the frame of reference for recovery gets anchored to the pre-crisis indicators - financial market and macroeconomic - irrespective of whether they are achievable or even desirable. Policies get therefore tailored with that objective in mind. It overlooks the possibility that fundamental structural conditions may have changed.       

No comments: