Thursday, 4 July 2013

So what’s the rush?

Having vanquished the threat of economic disaster, the Federal Reserve sets its sights on a return to normality.  

It would seem to be anyone’s fantasy to have the power to influence the direction of the global economy and have investors hanging off your every word.  But it is more of a nightmare for Ben Bernanke, the chairman of the Federal Reserve.  Despite concerns over the strength of the economic recovery in the US, the Federal Reserve is already planning to shed its guise of defender of the economy.  But why the rush?

The Federal Reserve has been thrust into the role of hero with monetary policy deemed to have mythical power to heal the ailing economy.  The limited resources at the hands of central banks have required the use of heavy firepower to stave off economic disaster.  But it is a victory that has come at a heavy price with central banks now deeply involved in the management of the global economy which is proving a difficult position to retreat from (for more, see The perils of doing too much).  Statements by Bernanke in the previous weeks which suggested that the day had been saved and further actions could be tapered off prompted investors to run screaming (refer to Monetary Policy in the Real World). 

The haste at which the Federal Reserve is keen to head for the exit despite concerns that the risk of economic meltdown has not been put to rest is mostly due to the perceived consequences of monetary policy.  Economists who run central banks typically have the personality of the bookish and reserved Clark Kent rather than that of a caped superhero.  Rather than believing in their own powers, economists have a faith in the ability of the markets to generate optimal outcomes.  So any actions taken from the top down which are not governed by market forces will generally result in distortions in the natural order of things.  The extent to which the Federal Reserve has had to ride to the rescue – slashing interest rates to close to zero and buying US$85 billion in bonds each month – has created forces that if left unchecked could result in the Federal Reserve being cast as the villain.

The Federal Reserve has been caught out in the past when led by Alan Greenspan for setting interest rates too low for too long.  The cheap rate of borrowing helped to fuel growth but this proved to be unsustainable when the global financial crisis kicked in, as the amount of debt had become too much to bear.  Low interest rates have not yet had anywhere near the same effect this time round as firms and consumers have been so worried about the future that they have been paying back their loans instead.  The key concerns regarding distortion at the moment is in the prices for stocks and bonds which have benefited from the Federal Reserve’s efforts to keep the economy moving (see Doing more harm than good).  Inflating an asset bubble at this time would be like fighting off one crisis only to plant the seeds of another.  And the Federal Reserve not only has to worry about the reactions of investors but also about the value of its own investments considering the US$3.5 trillion in assets already on its books. 

But it is perhaps the psychology of those running the Federal Reserve that is the overriding reason behind a desire to retreat into the shadows.  The Federal Reserve is not comfortable in the spotlight and prefers to operate in the background as a steady hand on the wheel rather than a dashing hero.  The improving economy in the US provides an escape route while other central banks are still on call ready to fight off economic stagnation.  The decision to move first out of the central banks and put down the big guns of monetary policy is bold but it is also prompted by a fear that further actions will require even more of a superhuman effort to tidy up the resulting potential mess.  

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