Fed Accommodation is at an End, Whether it Tapers or Not

Beyond the decision to extend its program of asset purchases, what were the most important takeaways from the September FOMC meeting? First and foremost, central bankers don't yet believe the recovery has found its sea legs. They described the trends that have prevailed under their current interventions as “… consistent with growing underlying strength in the broader economy.” But they also described further rate increases as a threat to that recovery. In the housing market, in particular, they are not ready to wager that the rebound has independent momentum. If it's taking flight on the market distortions behind cheap money, it may not survive anything but rock-bottom borrowing costs.

Reigning in the Long-Term Forecast

The Fed's basic argument for accommodation is not in widespread dispute. The economy is growing slowly in the post-crisis era, below its potential rate, and is projected to remain sluggish in the near- and medium-term. The tepid pace of job creation is an even greater source of frustration. Unemployment rates are down from a year ago, but sliding labor participation accounts for too much of that result. Even with subdued inflation, real household incomes are declining.

Looking ahead, the larger source of concern is the Fed's diminishing assessment of the US economy's innate strength. The central tendency for the “longer run” was revised down yet again in last week's minutes, this time to a range of 2.2 to 2.5 percent. Just two years ago, when the Fed held a brighter vision of the post-crisis era economy, 2.5 percent was the central tendency's floor, not its upside.

Proportional Response

Unconstrained by inflationary pressures, the Fed's unambiguous mandate is to juice a weak real economy with accommodative monetary policy. The question is which levers to pull. Conventional policy depends primarily on targeting the federal funds rate. But the Fed has reached the limit of convention; the effective funds rate has been at zero for nearly five years. Markets don't see the short-term yield coming off its lower bound until early 2015.

Memories are short. Even if it no longer seems like it, current monetary policies are unconventional by any reasonable standard. Running its primary machinery at full throttle, additional measures by the Fed are extraordinary responses to extraordinary conditions. Implied in the persistence of an $85 billion asset purchase program, the Fed does not believe that our current problem is limited to slow growth and elevated unemployment.

A Temporary Reprieve Against Inevitable

The Fed exerts sway over the long end of the yield curve, not control. If it were otherwise, the yield on the 10-year Treasury would not have been allowed to spike so abruptly in May and June. Furthermore, last Wednesday's announcement would have pushed rates much lower. The stock market rallied on the alleged surprise, but not because investors believe another month of weaning will suddenly propel us to stronger growth.

Irrespective of the decision on asset purchases, it is naïve to think the Fed can precisely engineer market outcomes. The days of artificially low risk-free yields cannot be sustained once global capital markets begin to demand higher returns. Even if the Fed was that muscular, tapering is imminent. It is not that muscular, so tapering as rates move higher is the best option for preserving credibility. On Friday, St Louis Fed President James Bullard described last week's extension of asset purchase as a “borderline” decision. However large the market's temper tantrum, the meetings in October and December may bring tougher love.