By Desmond Lachman
On Wednesday, September 18, the Federal Reserve’s Open Market Committee (FOMC) will hold one of its more important monetary policy setting meetings this year. For at this meeting the FOMC will need to decide not only whether to start tapering its US$85 billion-a-month bond-buying program. It will also need to decide how to communicate its intentions with respect to the winding down of that program going forward. How well the FOMC handles those decisions could have an important bearing on the US economic recovery especially in an increasingly uncertain domestic and global economic environment.
At his press conference following the FOMC’s last policy setting meeting in July, Fed Chairman Ben Bernanke managed to seriously rattle financial markets with his inept communication as to how the FOMC would exit from its massive US Treasury and mortgage-backed security bond buying program. Instead of confining himself to a statement that the FOMC would scale down its bond purchasing program over time in accordance with how the US economy might be performing, he provided a specific timetable as to how the program might be unwound. In particular, he mentioned that if the FOMC’s forecast of the future evolution of the US economy were to materialize as expected, he could envision a start to the tapering being made before the end of 2013 and a complete end to the bond buying program by the middle of 2014.
Since Mr. Bernanke first broached the issue of Fed tapering in May this year, long-term US interest rates, including most importantly mortgage rates, have increased by over 1-1/4 percent. This has to raise questions as to whether it is reasonable to expect a continuation of the strong pick-up in housing demand, which has been an important driver of the US economic recovery to date. Indeed, there are now indications that the US economy is not gathering steam as the Federal Reserve had hoped. According to Moody’s Analytics, which tracks US high-frequency economic data, the US economy seems to be tracking only around 1.5 percent economic growth in the current quarter rather than the 2.5 percent growth for which the Fed had hoped. This slowing would seem to be consistent with the lackluster employment growth over the past two months.
A political battle
Aside from a slowing US economy, next week’s FOMC meeting will be occurring on the eve of an all too likely political battle over the raising of the US debt ceiling. Emboldened by President Obama’s missteps in the Syrian crisis, one has to expect that the Republican controlled House of Representatives will harden its stance with respect to the raising of the US debt ceiling. While this issue will very likely be sorted out in the end, judging by last year’s experience one has to expect a period of political uncertainty that could dent household and investor confidence in the management of the US economy.
Further complicating the FOMC’s decision as to the timing and as to the appropriate pace of tapering is the impact that its decisions might have on the rest of the global economy. Over the past few months, as long-term US interest rates have risen, capital has been repatriated to the United States at a rapid rate from the erstwhile booming emerging market economies, which until recently had been the main engine of global economic growth. As a result, a number of major emerging market economies like Brazil, India, Indonesia, South Africa, and Turkey have all seen substantial weakening in their currencies that is all too likely to result in a marked slowing in their economies. In deciding on the pace of tapering next week, the FOMC has to be mindful that tightening global liquidity at this stage could deepen the emerging market currency crises, which could very well have knock-on effects on a still troubled European economy.
The taper has to happen
Almost everyone agrees that the Federal Reserve’s bond buying program cannot continue indefinitely since that would run the risk of creating asset and credit market bubbles. However, in view of the domestic and international uncertainties surrounding the US economic recovery one must hope that the Fed proceeds with utmost caution in its tapering decision. In that spirit, one would hope that should the Fed start tapering at its next meeting, the Fed will limit itself to the US$10 billion to US$15 billion initial cut in its monthly bond purchases that the market is expecting.
Equally important, one has to hope that the Fed recognizes the real risk that the US economy could falter anew and that renewed monetary policy stimulus might be required down the road. In that spirit, one would hope that in outlining the future course of Fed policy, Mr. Bernanke will make it clear that the pace of future Fed bond buying will depend very much on the evolution of the US economy and that in case of need the pace of Fed bond purchases might as easily be stepped up as be reduced.
Desmond Lachman is a resident fellow at the American Enterprise institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.