Reading the Fed’s Minutes: Mismanaging Expectations?

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The publication of the Fed’s minutes from the July Federal Open Markets Committee (FOMC) meeting triggered a flurry of headlines ranging from “Fed remains committed to tapering [its asset purchases] by year end” to “No rush to taper.” Since the traditional central bankers’ gathering in Jackson Hole this month will provide little to no clues about future action, all eyes are now turning to the September FOMC meeting.

The third round of quantitative easing (QE3) is now a year old. Whether it has managed to spur self-sustaining growth in the United States still remains a very much unanswered question. While the recovery seems to be gaining momentum, the Fed obviously is worried about a number of factors — not least of which is the effect of the fiscal drag caused by sequestration earlier this year. When Congress returns from recess in September, it will face old challenges that could very well lead to further fiscal tightening and weaken the United States’ growth outlook. This alone should give pause to all those that are convinced that the Fed should — or is about to—slam on the brakes. The picture is still far too hazy to allow for premature decisions. Indeed, the Fed will probably try to first address its current inability to credibly explain to investors that a step-by-step exit from its bond-buying program does not automatically translate into a tighter monetary policy. In the words of former Fed official Stephen Axilrod, “the zero funds rate became so intimately tied into a policy of quantitative easing that it is difficult to distinguish it as a policy instrument by itself.” This is a problem.

Even more troubling are developments in emerging markets (EM). They are contributing to a sell-off of U.S. treasuries by a number of countries that are trying to support their currencies versus the dollar in order to stop or reverse the outflow of foreign capital. The rush for the exit by international investors is, therefore, not only weakening some EM economies, which should not necessarily be the Fed’s concern, but also contributing to a rise in U.S. treasury yields, which should be the Fed’s main concern. In fact, as a consequence of rising treasury yields, mortgage rates in the United States are rising as well. Given the central role a rebounding housing market played in the recent strength of the U.S. economy, this development is probably coming too soon. In fact, according to various media reports, Wells Fargo — by far the largest home lender in the United States — has decided to cut 2,300 jobs from its mortgage production unit because of already weakening demand for home loan refinancing.

Then, there is the question of where capital outflows from EM are headed — back to advanced economies as some are suggesting? Will the capital only flow toward perceived safe havens, such as the United States or Germany, or across a broader spectrum of countries, including those that have recently suffered because of the euro crisis, thereby potentially lifting all boats? On the other hand, could a suddenly rising liquidity tide cause new asset bubbles or even higher inflation in the United States and/or European economies? Could it be that, after all the taper talk, the Fed could be forced to significantly tighten monetary policy much sooner than it actually wanted to?

Whatever the answers, it is clear that embarking on quantitative easing experimentation is proving to be much easier than phasing it out in an orderly way.