Mohamed El-Erian, chief executive and co-chief investment officer at PIMCO, discusses the options facing the Federal Reserve as chairman Bernanke prepares to address Congress.
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Over the next two days, Fed Chairman Ben Bernanke will be on Capitol Hill for his semi-annual report to Congress. Markets will be listening carefully to him, particularly with a view to assessing three issues: the extent to which the Fed feels that additional policy steps are needed; the potential form of such measures; and whether the Fed has the required degrees of freedom to act.
The need for additional measures comes down to the Fed’s evaluation of the outlook for the economy, as well as the view on the correct policy mix (monetary/fiscal/structural).
In its FOMC release last week, the Fed did revise its projections to reflect some greater headwinds to economic recovery in the US. But the revisions were small. Indeed, the Fed is nowhere near those that worry seriously about a double dip; and it is only grudgingly moving towards the scenario of muted growth, persistently high unemployment and continued de-leveraging of the US economy.
It will be interesting to see whether Chairman Bernanke goes beyond the revisions to the outlook released last week. I suspect he will not.
On the best policy mix, the Fed has to continuously make assessments in areas that lie outside its domain. Indeed, many would argue that the policy emphasis today is best placed on those areas. Realistically though, there is little hope that the Fed can rely on sufficient actions from others to invigorate a recovery that is losing steam. People will continue to look to the Fed.
How about the institution’s potential policy options?
Theoretically, the Fed has five broad (and not mutually exclusive) approaches available if it deems—and I suspect it is not ready to do so yet—that additional policy actions are needed: hyper time extend the “exceptionally low for an extended period” interest rate signal; push banks to lend more by cutting the interest it pays on reserves; directly extend loans to certain segments of the non-financial economy; resume asset purchases; and cap interest rates.
Each of these measures seeks to put more credit and liquidity in the economy, with the hope that this encourages economic activity. Yet, with deleveraging and the liquidity trap in operation and with structural issues increasingly acting as notable constraints, each of these measures also involves collateral damage and unintended consequences; and the potential costs increase should policy progress down this spectrum of possibilities.
When it comes to the degrees of freedom to act, the Fed has been gradually losing policy flexibility and effectiveness. Part of this has to do with the structural dimensions of the problems; part results from the political reaction to the Fed’s quasi-fiscal operations; and part is driven by concerns about further erosion in the operational and conceptual integrity of the Fed.
Putting all this together, it is likely that Chairman Bernanke will refrain from announcing anything notable today and tomorrow. Instead, he will likely try to reassure us on the direction of the economy (yes weak, but recovery is slowly taking hold), remind us of what the Fed has already done, and stress the institution’s vigilance should additional policy measures be needed.
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The writer is CEO and co-CIO of PIMCO. Some of El-Erian’s earlier commentaries for FT Alphaville are available here.