FED REVIEWS FORMER PLOT LINES / THE FINANCIAL TIMES GLOBAL INSIGHT ( HIGHLY RECOMEMNDED READING )

Global Insight

June 3, 2012 6:43 pm

Fed reviews former plot lines

By Robin Harding in Washington

Here we go again. Summer in the US is a time for sequels: This year we have The Dark Knight Rises, The Amazing Spiderman, another Jason Bourne thriller and Men in Black 3.



For the third year in a row we also have an economic slowdown: payrolls growth fell to 69,000 new jobs in May. This slowdown may be the most wretchedly disappointing of them all, because the fundamentals of the US economy have been looking better, and it will be wretchedly difficult to respond to.






All of the policy options are sequels as well. Perhaps we could try Fiscal Stimulus 4, Operation Twist 2, Quantitative Easing 3, or another episode of Fixing Housing Finance, although most people have given up on that one because the rambling plot lines never seem to go anywhere.




.This slowdown seems to be largely imported from Europe and the rest of the world so US policy makers are powerless to tackle it at source. Given that, some sort of fiscal action would probably be most effective, especially if it reduced uncertainty about tax and spending next year: the so-called fiscal cliff. Congress, however, is unlikely to risk giving anybody a substantive or political victory before the election.






That leaves the Fed. On Thursday its chairman, Ben Bernanke, will testify to Congress on the economic outlook. As has happened so often during the past five years, a routine hearing will turn into a crucial policy moment, setting expectations for how the Fed will act at its policy meeting two weeks later.




.Recent talk from the central bank has leaned away from further action. Only ten days ago, William Dudley, president of the New York Fed told CNBC that he was “a little bit more confident that the economy's going to keep growing” than in previous years.






But the situation is reminiscent of last August. All signals before that meeting were for policy to stay unchanged, not least because inflation was higher than it had been in 2010, the last time the Fed acted, and it was rising rather than falling.




.In the last ten days leading up to that August FOMC, however, came the debt ceiling debacle, an S&P downgrade of US debt, and full scale market panic about growth. In the end, that meeting produced the Fed’s forecast of low rates “at least through mid-2013”. The next Fed meeting will conclude on 20th June, three days after Greece holds fresh elections, and the potential for similar market turmoil is considerable.




.That August 2011 meeting is also important for what it, and other recent actions, reveal about the Fed’s preferences. The central bank keeps trying to come up with a communication strategy to explain how it will respond to future data, but so far it has failed, and hence its past actions are the best guide to the future.




.Whenever markets cease to believe that future inflation will be 2 per cent, or whenever the economy loses momentum such that unemployment no longer looks like falling, the Fed has reacted strongly. A break with that past pattern – the economy’s main insurance policy – would be perilous.



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“We will continue to assess, you know, looking at the economic outlook, looking at the risks, whether or not unemployment is making sufficient progress towards its longer-run normal level, and whether inflation is remaining close to target,” said Mr Bernanke at his last press conference.




.Mr Bernanke also indicated that 100,000 new jobs a month might be the level that keeps unemployment flat, so that indicator is flashing red. Inflation expectations have remained fairly stable so far – reflecting the fact that this slowdown seems to be imported from Europe rather than homegrown – but they will surely drop if employment growth continues to stall.




.If the Fed does choose to act then its main options are switching more of its existing investments into long-term securities, a so-called Operation Twist 2 – which is feasible and low risk but limited in capacity – or it could buy more assets outright, most likely mortgage-backed securities, in a QE3.



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That should be more effective, but might backfire if Republicans used QE3 as an election issue to attack the Fed, making markets question future policy stability. On Thursday, Mr Bernanke may indicate which if any sequel he prefers.



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Copyright The Financial Times Limited 2012