I suspect that I will always remember where I was when the Federal Reserve stunned markets on Wednesday by deciding not taper its experimental support for markets and the economy — just like I suspect that I will always remember where I was on May 22nd when the Fed surprised many by indicating that a taper was likely to be forthcoming. In-between, markets have gone on a wild roller coaster roundtrip that also speaks to what continues to be a disappointingly tentative economic recovery and frustratingly weak job creation.
All this is quite perplexing given that the Fed is not in the business of surprising markets, and understandably so. Surprises tend to increase uncertainty premiums which then can act as a tax on financial intermediation and economic activity. They can also undermine the credibility of an institution that is central to the wellbeing of the nation.
If anything, the Fed under Ben Bernanke has made a point of enhancing “transparency.” Mr. Bernanke is the most communicative chairman in Fed history. He and his colleagues are releasing more data and projections than ever before. And Janet Yellen, the Fed’s vice governor and Mr. Bernanke’s likely successor, has led a comprehensive transparency initiative.
Yet the Fed has ended up surprising in major ways over the last few months, leading to wild gyrations in markets. The Dow collapsed by 5% between May 21st and June 24th, before surging by 8% to a new record close on Wednesday. Commodity and bond markets have also been quite volatile, with the benchmark 10-year Treasury unusually trading in an almost 50 basis point range.
Changes in underlying economic fundamentals do not warrant such volatility. While the economy continues to heal, it is has remained stuck in a multiyear, low-level growth equilibrium that frustrates job creation and worsens income distribution.
It could be that the Fed is really worried about the upcoming congressional battles over funding the government and lifting the debt ceiling. As illustrated by the debacle of the summer of 2011, a slippage could undermine economic performance. And we should never underestimate the appetite of our polarized Congress for self-manufactured challenges. Having said this, the Fed usually prefers to be reactive rather than proactive in such situations.
It is also hard to argue that the Fed has made a major discovery about the longer-term impact of what is after all a highly experimental policy approach. If anything, our central bankers (and, I would argue, everybody else) are essentially in the dark when it comes to the specific evolution over time of what Mr. Bernanke labeled back in 2010 the “benefits, costs and risks” of prolonged reliance on unconventional monetary policy.
We have to go elsewhere to explain the Fed’s unusual surprises. And my preferred explanation at this point — based on partial information and a gut feel — has to do with decision making under considerable uncertainty and changing leadership.
When faced with a challenging decision, we all love focusing on what can go right. It is our natural comfort zone. Yet, particularly in circumstances of extreme uncertainty, it is also important to assess the potential scale and scope of what can go wrong.
The Fed already has a feel for this.
The mere mention of a taper last May did more than cause unusual market volatility. It contributed to a sudden adverse U-turn in the prospects for interest rate sensitive sectors of the economy (including a 14 percent decline in home purchase applications, 66 percent drop in the refinancing index, and 18 percent fall in home affordability). It also contributed to the difficulties emerging economies’ face in maintaining high growth.
Faced with this experience, and knowing that they could end up making a policy mistake (even though they are trying their utmost to avoid it), Fed officials may well prefer excessive monetary accommodation to premature tightening. The expected change in leadership may well serve to accentuate this.
How about the implications for the rest of us?
While noting the boisterous reaction of financial markets to Wednesday’s non-taper, we should remember that what is essentially in play is an unusual disconnect between exuberant markets and a sluggish economy. And this disconnect is maintained by a Fed policy wedge betting that improving economic fundamentals will validate over time artificially high asset prices.
Both the private and public sector can enhance the probability of success for the Fed’s historic policy bet and, therefore, the well-being of the economy.
Large companies, including multinationals, are still sitting on a huge pile of cash and their debt profiles have benefited tremendously from the Fed’s financial repression (artificially-low interest rate) regime. That is the good news. The bad news is that they prefer to use this cash for stock buybacks and higher dividend payout as opposed to investing in new plant, equipment and hiring.
Banks also have a ton of cash on their balance sheets. Yet too little of it makes its way into the economy; and even less when it comes to funding small- and medium-sized
Government agencies have better tools than the Fed to deal with what fundamentally ails the economy and the labor market. But they remain on the sideline, paralyzed by the unusual extent of political polarization on Capitol Hill.
The bottom line is simple yet consequential.
The latest Fed surprise is yet another example of a broader phenomenon that is visible in many segments of our economy. Whether by choice or necessity, America is favoring immediate stability and inaction. In the process, we are foregoing comprehensive policy implementation, coordinated responses, and win-win public-private partnerships — or what is critically needed to restore our economy on the path of sustained high growth, dynamic job creation, improving living standards, and lower income and wealth inequalities.
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