How the Fed Made Its Own Bed

April 5th, 2016 by

Source: Slate

Source: Slate

The Federal Reserve has no one to blame for its current conundrum than itself. By purposely sending mixed signals and hesitating to act in the interest of the stock markets, the central bank has created its own nightmare.

To Hike or Not to Hike

Since the beginning of 2015, the Fed has played a dangerous game of cat-and-mouse—with itself. Although the U.S. central bank makes unilateral monetary policy decisions that impact the entire economy, it has often fallen victim to internal squabbles. The Federal Reserve Open Market Committee (FOMC) that makes policy decisions has 12 voting members. Lately, those dozen voices have scarcely been in unison.

fischer

Fed Vice Chair Stanley Fischer

While most of the FOMC’s voting members have been talking up higher rates so far this year, the committee’s Chair and Vice Chair, Janet Yellen and Stanley Fischer (respectively), have largely expressed the opposite sentiment. Some describe this as a battle between “hawks” and “doves.”

The stock markets tend to prefer that interest rates remain low. This “easy-money” environment helps to artificially make economic conditions look better than they are. (That’s the whole point of stimulus and accommodation in economic policy.) In the interest of protecting Wall St from a devastating downturn, Yellen has used her leadership to steer the Fed away from raising interest rates.

Too Little, Too Late

By many measures, the U.S. has escaped the worst effects of the global economic turmoil. In fact, nearly all of the Fed’s own benchmarks for when interest rates should be normalized have been met, or nearly so. Its mandates for “full employment” and currency stability (and, unofficially, 2% inflation) are all at or near acceptable levels. Yet the central bank has still hesitated to hike after increasing the federal funds rate by 0.25% last December.

Source: MarketWatch

Source: MarketWatch

By many accounts, December was too late for the Fed to wait. Moreover, after finally choosing to lift off rates from near-zero levels, the Fed changed course when it saw the stock markets tank in response in January. This was a necessary correction of the equity markets, yet Yellen et al. took it upon themselves to keep Wall St happy by holding off on any further changes to interest rates.

One thing that markets are especially sensitive to is rapid changes in interest rate conditions. Quick reversals in expectations regarding rates are equally damaging. By choosing not to gradually tighten monetary policy over 2015 and so far in 2016, the Federal Reserve has waited too long. Hastily hiking rates now would compound its problem. On top of that, its change of heart about the rate hike path has been problematic by itself.

bankIt’s not just investors who are miffed by the uneven action—or lack thereof—from the Fed. Its peers around the globe (other central banks, that is) are also complaining. Because the dollar still occupies such a central place in the fiat currency system that makes up the world’s economic order, decisions by the Fed have a profound effect on the policies of other central banks. Both the Reserve Bank of Australia (RBA) and the Bank of Japan (BOJ) have been frustrated by the inconsistent and indecisive moves by the Federal Reserve.

Making Its Own Mess

Did the Fed simply misread the situation? Perhaps. Its wavering resolve and confused outlook have proven to be a detrimental response, no matter the reasons why. Now, it has little ammunition (read: policy tools) left at its disposal to remedy the mess it created.

 

The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.

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