Three major challenges for the FED

In December this year the Federal Reserve celebrates the 100th anniversary of the signing of the Federal Reserve Act, and early next year Janet Yellen will become the 15th Chairman of the central bank. She will face some formidable challenges over the next few years, but three broad themes stand out.

Communicate with the market
Whatever the policy outcome, the Fed has committed to providing transparency on what it is likely to do and why. Ms Yellen has been instrumental in developing the new communication strategy, but trying to manage expectations of the Fed’s reaction function could harm as well as help the Fed’s credibility in the eyes of the market.

In particular, any discussion of specific indicators brings a risk that the market over-focuses on those indicators. When the economic data turns or is contradictory, or FOMC members change their interpretation of the data, promises may be broken. September’s surprise decision to delay the start of the QE taper is a case in point: the Fed had given guidance conditional on the unemployment rate, the market became convinced that the FOMC would taper in September, other measures of activity deteriorated and the FOMC decided not to taper.

Greater transparency also exposes the wide range of opinion among FOMC members. The latest FOMC minutes show a split on the tapering decision in September. Interestingly, the group for the taper appear to have been more concerned about the efficacy and costs of continuing asset purchases, than the data supposed to drive the decision. Differing views on the direction of policy are healthy and to be expected, but fundamental differences on the efficacy of key policy tools are a problem. Trust in the central bank is vital to effective policymaking and the scale of the challenge facing Ms Yellen in this respect is equal to that faced by the Fed in the 1930’s and 1970’s.

Exit unconventional policy
Judging the trade-off between the risk and reward of unconventional policy and the timing and execution of the eventual exit strategy will be the Fed’s biggest challenge. There is a limit to how much stimulus monetary policy can provide and the risks are becoming more apparent.

The volatility in Treasury yields since May is evidence of the heightened sensitivity financial markets now have to Fed activity. Price movements increasingly reflect reactions to statements and speeches, rather than the assessment of economic fundamentals. This has bred an over-reliance on the Fed’s view of the world, but what if their assessment changes? A badly managed exit risks a spike in bond yields that could trigger a negative feedback loop into the real economy. Meanwhile, keeping policy too loose in a recovery encourages carry trades and excessive risk-taking, and raises the chance of a spike in inflation.

The FOMC believes that it has the tools to flex policy according to its assessment of incoming data, but all market participants should remember that the process is still experimental. The Fed will taper QE before it attempts to raise rates: this taper, if it is to avoid significant market disruption, will take time. A reverse repo tool, designed to drain excess liquidity from the banking system and thereby allow market rates to rise in line with the Fed Funds target rate, has been tested under relatively benign conditions and in small size: draining larger amounts could be more difficult.

An option for an emergency tightening would be to sell assets from the Fed’s massive $3.6 trillion balance sheet. However, the Fed would be likely to realise a loss on those assets and there remain interesting questions about how the consequent losses would be treated in the Fed’s accounts. Recent shenanigans over the debt ceiling and legislation to restrict the Fed’s freedom of action suggests there is no reason to expect full support for the central bank from the US government and legislature.

Fulfil the mandate

Effective policy setting also requires agreement among FOMC members on the goals of monetary policy. Maintaining full employment and price stability are the FOMC’s longstanding aims, but the Chairman of the Federal Reserve also sits on the Financial Stability Oversight Council, set up by the 2010 Dodd-Frank act. In addition, the FOMC’s dual mandate can only be achieved, and monetary policy can only be effective, with a stable financial system.

This raises the question of whether regulatory and supervisory controls will be enough to contain the build up of systemic risk, while the Fed pursues its first goal of full employment by keeping interest rates lower for longer? Are the three objectives even compatible? One faction within the Fed argues that limiting excess leverage and liquidity in one part of the economy will simply shift it to another. Bubbles inevitably rise to the surface.

Successful regulation also relies on being able to take a step back and decipher unusual deviations from structural trends. To decide whether the costs of financial disruption are worth bearing, and when to lean against pro-cyclicality in the financial system, may be asking too much. Conventional wisdom seems to find a rational justification for any build up of financial imbalances: recall then Fed Chairman Alan Greenspan’s assertion in 2002 that credit derivatives had helped disperse systemic risk (later revised).

Ultimately, these three challenges are inextricably linked. Ms Yellen’s tenure as Chairman begins on 1st February 2014, but as for her predecessors, her legacy will be debated for decades to come.

By Tim Foster.

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