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Steering locked

25 January 2012 By Martin Hutchinson

The U.S. Federal Reserve could be setting itself up for an uncomfortable surprise. It extended its commitment to keep interest rates near zero from about 18 months to three years on Wednesday. Job creation, the departure of Chairman Ben Bernanke or rising inflation could force a damaging reversal before then – or lead the Fed to drag its feet to avoid one.

In his press conference, Bernanke said that with the fed funds rate at zero the U.S. central bank had two means of affecting monetary policy, namely securities purchases and guidance. By pushing out the date when it expects rates to start going up from mid-2013 to late 2014, the Fed has potentially reduced yields on long-term paper.

Bernanke also outlined the Fed’s long-run goals and policy strategy, setting a soft inflation target of 2 percent, based on the annual change in the price index for personal consumption expenditures. He noted that a hard target would be incompatible with the Fed’s dual mandate, which includes promoting full employment as well as minimizing inflation.

The U.S. unemployment rate was 8.5 percent in December, down 0.6 percentage point since August. Should that pace of improvement continue, unemployment would reach the Fed’s estimated “normal” range of 5.2 percent to 6 percent by mid-2013 – well before Bernanke’s new zero-rate end date.

Meanwhile, the PCE price index was up 2.5 percent in November from the previous year. Given that’s already above the Fed’s soft target, it seems likely that inflation will rise sufficiently within the next three years to warrant an interest rate rise. Finally, Bernanke’s own term of office ends in January 2014. This year’s elections may determine whether he will get another term, and a different chairman could spearhead a very different policy.

Even though the Fed’s 2014 date isn’t set in stone, an earlier reversal would damage its credibility. In addition there could be a temptation not to deviate from its announced path, which might delay needed interest rate hikes too long if unemployment or inflation trends demand them. In short, the Fed has roughly doubled the risk of being whipsawed by the market.

 

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