international analysis and commentary

The Fed facing a slow US recovery


The Federal Reserve has recently inaugurated its new communication strategy, which includes a specific indication of where it expects interest rates policy to be in the coming years. It has used the opportunity to launch an extremely “dovish” message, saying it expects to keep interest rates at zero (in the current 0-0.25% range, to be precise) “at least through late 2014”. In addition, the Fed will continue to extend the average maturity of its securities holdings, will keep rolling over its holdings of Treasuries and agency mortgage-backed securities as they mature, and leaves the door open to a possible third round of quantitative easing (QE3).

The Fed justified its extremely dovish stance with a very simple and logical rationale: it expects that over the next three years inflation will remain at or below target (2%), while unemployment will decline only slowly and remain above its equilibrium rate, which the bank estimates between 5.2% and 6%. Members of the Federal Open Market Committee expect unemployment still above 7% in 2014 (in a 6.7-7.6% range); this would represent a meager 0.5 percentage point decline per year over the next three years, from the end-2011 level of 8.5%. It’s hard to argue with the Fed’s assessment of inflation: the Consumer Price Index measure is at 3% but declining, and just over 2% if we exclude the volatile energy and food components. The Fed’s Chairman, Ben Bernanke, argued that with global growth decelerating, commodity prices are likely to at last stabilize, while high unemployment should continue to cap domestic wage pressures.

Unlike the European Central Bank, the Fed has a dual mandate: low and stable inflation, and full employment. Therefore, it stands to reason that if there is no inflation risk, monetary policy should be fully geared to reducing unemployment and supporting the fragile recovery: the latest US activity data have been somewhat better than expected, but remain mixed, and risks to the global growth outlook remain on the downside, particularly with persisting financial markets tensions in Europe.

In fact, the Fed’s forecasts beg an uncomfortable question, which was put quite bluntly to Bernanke during the latest press conference: since the Fed’s own forecasts suggest that three years from now unemployment will still be too high, shouldn’t the central bank act more aggressively today?

The answer is: in principle, yes, but in practice it is getting harder to identify the right measures, and more and more important to weigh their costs and benefits. QE (quantitative easing) has had limited success. It has been successful in lowering interest rates across the maturity spectrum and in boosting asset prices, but this has not transmitted to the real economy the way one would have hoped, partly because house financing is held back by the significant overhang of housing stock and delinquent mortgages. There is no reason to believe that another round of QE would be any more effective than the previous two.

This would appear to send a rather depressing message: the Fed is essentially telling us that unemployment will remain high for another three years, and that there is not much they can do about it.  Some therefore argue that the Fed’s dovish stance might backfire, weakening business and consumer sentiment. On balance, however, the Fed thinks that more bullish forecasts would not be credible, and prefers to tell the public that the central bank has no illusions and is prepared to do all it can to keep supporting the recovery. Given the disappointing pace of the recovery so far, this is probably the best course of action.

There is also an international/exchange rate dimension to the Fed’s strategy, quite obvious in these days of higher trade tensions. The European Central Bank has recently launched its version of QE, and the Euro has weakened on cue, falling to 1.3 against the US$ from over 1.4 just three months ago. The Fed’s dovish stance could help prevent a further US dollar appreciation, thereby safeguarding competitiveness and export performance (exports have been an important contributor to the recovery so far). In this particular game, the ball is now back in the ECB’s court.

 The overall message though is quite startling. The Fed funds rate has been at zero for over three years already; by end 2014 it would be six years. Meanwhile, the Fed and the Bank of England have more than tripled the size of their balance sheets, and the ECB is on the same track. This is an enormous amount of liquidity that can come quickly back in play if the global recovery confirms its resilience and the Eurozone does in fact avoid disaster. Combine this with high levels of public debt, and we have a set of imbalances that begins to look quite respectable, and will eventually need to be reckoned with. I am not arguing that monetary policy should be tightened in a hurry today—but we need to think ahead about how these new imbalances will be unwound, and with what consequences.