For a while now, US economic policymakers have been dealing with the challenge of driving a car with a sputtering engine up a hill, says El-Erian, chief executive of Pimco and author of ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change‘.
They needed to do a lot to keep the car moving forward; or at least stop it from rolling back too quickly.
Wednesday’s announcement from the FOMC suggests a possible change in mindset at the US Federal Reserve. Specifically, the language is consistent with the view that the road is now flatter, if not flat. Accordingly, the Fed is taking some pressure off the liquidity accelerator.
The change is consistent with the notion in Washington DC of growing confidence in the “green shoots” of growth developing into a more endogenous and sustainable economy-wide growth process.
This change is not without risk. After all, policymakers are trying to strike a very delicate balance between doing too little and doing too much in stimulating the economy. In doing so, they inevitably end up targeting a first-best policy outcome, yet are likely to end up with a second, third or fourth-best.
The risk is that this change turns out to be a premature relaxation of a critical policy effort, thereby increasing the possibility of a prolonged period of anaemic growth, employment losses, and deflation. After all, history suggests not only that the right balance is very difficult to strike; it also suggests that it is easier to correct later on for doing too much as opposed to doing too little.
How about the markets’ reactions to the Fed’s policy announcement? Well, it was somewhat confused – and understandably so.
The surge in the US stock market suggests that equity markets are taking comfort in the signal from Washington DC that things are indeed getting better. In contrast, the backup in rates in the bond market points to concern that policymakers may not be doing enough to contain borrowing rates in the economy, including the mortgage rates so critical to stabilising the housing market.
Overall, all this speaks to the reality that we are on a bumpy journey to a “new normal.” Don’t unfasten your seat belt - just yet.
Related links:
Fed expects weakness to persist – FT
Full text, Fed statement – US Federal Reserve
Mohamed El-Erian: Bank tests we should get stressed about – FT