The difference between “and” and “or” could undo the Federal Reserve. At its meeting Dec. 12 the Federal Open Market Committee replaced its estimated duration for low interest rates with thresholds for the unemployment rate and inflation. If reality makes the two measures diverge, the new approach could prove rocky for markets.
Last time around, the Fed suggested it would keep short-term rates near zero until at least mid-2015. Now, it’s replacing that with the idea that its loose monetary policy probably won’t change while unemployment is above 6.5 percent, inflation a year or two out is forecast to be below 2.5 percent, and long-term inflation expectations are under control. That’s “and” rather than “or.” In theory, that means crossing any one of these thresholds – vague as the last one is – could have the Fed rethinking its policy.
But it’s easy to read this as saying the Fed won’t tighten policy unless all these indicators are the wrong side of the thresholds. That could breed confusion if, say, unemployment continues declining only slowly, as it has for the last two years or so, while inflation quickly gathers steam. Plus as the relevant economic indicators approach the Fed’s thresholds, market responses could be odd. A drop in the unemployment rate that brought it within range of the threshold ought to be good economic news, but investors might fear a withdrawal of easy money by the U.S. central bank and react badly instead.
Then there’s the Fed’s ramping-up of quantitative easing, or bond-buying. Chairman Ben Bernanke made clear that he is worried about the possible negative economic impact of the so-called fiscal cliff, the tax increases and cost cuts that could come on Jan. 1 if Congress can’t agree otherwise. While he knows the Fed alone can’t offset that, it’s also surely a factor in flooding markets with yet more cheap money. If those fiscal shifts do happen, the United States will suddenly need to borrow less. The Congressional Budget Office reckons the deficit would fall to under $400 billion in the year to September 2014. But the Fed would be trying to buy $540 billion of Treasury securities every year.
That conflict between monetary and fiscal policy is another potential source of confusion. Add the new focus on specific economic indicators and Bernanke could easily find he has set the stage for volatility, rather than the Fed’s desired stability, in financial markets.