TAPER IN A TEA POT : THE FED´S TWEAKING OF MONETARY POLICY / THE FINANCIAL TIMES COMMENT & ANALYSIS

December 19, 2013 8:02 am

Taper in a teapot: The Fed’s tweaking of monetary policy

By Barry Eichengreen

Value of Bernanke’s gesture is mainly symbolic, signalling desire to return to business as usual

The decision by the US Federal Reserve to reduce the monthly rate of security purchases by $10bn is best dismissed as a taper in a teapot. It is much sound and fury signalling not very much.

In effect, the Fed tightened current monetary policy almost indiscernibly, while at the same time using forward guidance – that is, the statement by the Federal Open Market Committee – to indicate that future policy would remain loose for at least slightly longer than previously anticipated.

This was a sensible way of tweaking the time profile of monetary policy. The US economy has been doing a little better than expected of late and can therefore digest this slightly tighter policy now.

At the same time, there remain serious concerns about America’s medium-term economic prospects. There is uncertainty about whether the disappointing pace of recovery will continue. There is the question of whether and when the alarming decline in the labour force participation, which has created the appearance but not the reality of lower unemployment, will be reversed. Given these uncertainties, it is entirely appropriate for the Fed to signal that it may be even more supportive of the economy in the medium term.

But these changes are inconsequential by the standards of the dramatic and unprecedented developments in monetary policy that we have seen since 2008; $10bn of monthly securities purchases are a drop in the bucket for a central bank with a $4tn balance sheet. Even if this month’s $10bn reduction is the first in a series of successive monthly steps in the same direction, it will take many months before the change has discernible impact on the Fed’s financial statement.

Wall Street may have had some trouble figuring this out on Wednesday afternoon, when the Fed’s statement seemingly threw the markets into a tizzy. But given a night’s sleep, stock traders should be able to recognise the Fed’s announcement for the non-event that it is.

The one consistent impact of Wednesday’s FOMC announcement was on the dollar exchange rate, which rose sharply against the yen and other currencies. This should not come as a surprise. Even a slightly tighter Fed policy now makes for a significantly stronger dollar, since monetary tightening will not only strengthen a currency but cause it to overshoot its new equilibrium value, other prices being slower to move. Thus, we should expect to see the dollar give back some of the ground it gained in coming days. The rise in the dollar will turn out to be another tempest in a teapot.

Finally, the FOMC announcement is unlikely to have much impact on emerging markets, in contrast to Mr Bernanke’s “tapering talk” last summer, which led to a very sharp emerging market correction. For one thing, investors this time are better prepared. They may not have been certain that tapering was coming this week but neither were they as surprised as they were by Mr. Bernanke’s statements last May.

For another, emerging markets are better prepared. Their exchange rates and stock markets are not as overvalued as last summer. Their financial markets are not as dependent as then on foreign money as they were then. Hence they are not as vulnerable to correcting downward.

Finally, policy makers in emerging markets have already gone one round with the Fed. If they gained anything from their less than happy experience last summer, they at least learnt what kinds of responses are more likely and less likely to reassure the markets.

The value of this week’s FOMC decision is mainly symbolic. It is a way for the Fed to signal to its detractors that it hears their criticisms of its unconventional monetary policies, and that it shares their desire to return to business as usual. The decision beats back some of the criticism to which the Fed is subject and diminishes prospective threats to its independence. But, at the same time, the central bank has also signalled that it is not prepared to return to normal monetary policy until a normal economy has returned. As Hippocrates would have said, it has at least done no harm.


The writer is professor of economics and political science at the University of California, Berkeley

Copyright The Financial Times Limited 2013.