The per­ils of Fed grad­ual nor­mal­iza­tion

The Pak Banker - - OPINION - Stephen S. Roach

BY now, it's an all-too-fa­mil­iar drill. Af­ter an ex­tended pe­riod of ex­tra­or­di­nary mon­e­tary ac­com­mo­da­tion, the US Fed­eral Re­serve has be­gun the long march back to nor­mal­iza­tion. It has now taken the first step to­ward re­turn­ing its bench­mark pol­icy in­ter­est rate - the fed­eral funds rate - to a level that im­parts nei­ther stim­u­lus nor re­straint to the US econ­omy. A ma­jor­ity of fi­nan­cial mar­ket par­tic­i­pants ap­plaud this strat­egy. In fact, it is a dan­ger­ous mis­take. The Fed is bor­row­ing a page from the script of its last nor­mal­iza­tion cam­paign - the in­cre­men­tal rate hikes of 2004-2006 that fol­lowed the ex­tra­or­di­nary ac­com­mo­da­tion of 2001-2003. Just as that ear­lier grad­u­al­ism set the stage for a dev­as­tat­ing fi­nan­cial cri­sis and a hor­rific re­ces­sion in 20082009, there is mount­ing risk of yet an­other ac­ci­dent on what prom­ises to be an even longer road to nor­mal­iza­tion.

The prob­lem arises be­cause the Fed, like other ma­jor cen­tral banks, has now be­come a crea­ture of fi­nan­cial mar­kets rather than a stew­ard of the real econ­omy. This trans­for­ma­tion has been un­der way since the late 1980s, when mon­e­tary dis­ci­pline broke the back of in­fla­tion and the Fed was faced with new chal­lenges. The Fed had, in ef­fect, be­come be­holden to the mon­ster it had cre­ated. The corol­lary was that it had also be­come stead­fast in pro­tect­ing the fi­nan­cial-mar­ket-based un­der­pin­nings of the US econ­omy.

Over time, the Fed's dilemma has be­come in­creas­ingly in­tractable. The cri­sis and re­ces­sion of 2008-2009 was far worse than its pre­de­ces­sors, and the af­ter­shocks were far more wrench­ing. Yet, be­cause the US cen­tral bank had re­peat­edly upped the ante in pro­vid­ing sup­port to the As­set Econ­omy, tak­ing its pol­icy rate to zero, it had run out of tra­di­tional am­mu­ni­tion. And so the Fed, un­der Ben Ber­nanke's lead­er­ship, turned to the liq­uid­ity in­jec­tions of quan­ti­ta­tive eas­ing, mak­ing it even more of a crea­ture of fi­nan­cial mar­kets. With the in­ter­est-rate trans­mis­sion mech­a­nism of mon­e­tary pol­icy no longer op­er­a­tive at the zero bound, as­set mar­kets be­came more es­sen­tial than ever in sup­port­ing the econ­omy. Ex­cep­tion­ally low in­fla­tion was the ic­ing on the cake - pro­vid­ing the in­fla­tion-tar­get­ing Fed with plenty of lee­way to ex­per­i­ment with un­con­ven­tional poli­cies while avoid­ing ad­verse in­ter­est-rate con­se­quences in the in­fla­tion-sen­si­tive bond mar­ket.

To­day's Fed in­her­its the deeply en­trenched moral haz­ard of the As­set Econ­omy. In care­fully crafted, highly con­di­tional lan­guage, it is sig­nal­ing much greater grad­u­al­ism rel­a­tive to its nor­mal­iza­tion strat­egy of a decade ago. The de­bate in the mar­kets is whether there will be two or three rate hikes of 25 ba­sis points per year - sug­gest­ing that it could take as long as four years to re­turn the fed­eral funds rate to a 3 per­cent norm. But, as the ex­pe­ri­ence of 2004-2007 re­vealed, the ex­cess liq­uid­ity spawned by grad­ual nor­mal­iza­tion leaves fi­nan­cial mar­kets pre­dis­posed to ex­cesses and ac­ci­dents. With prospects for a much longer nor­mal­iza­tion, those risks are all the more wor­ri­some. Early warn­ing signs of trou­bles in high-yield mar­kets, emerg­ing-mar­ket debt, and eu­ro­zone in­ter­est-rate de­riv­a­tives mar­kets are par­tic­u­larly wor­ri­some in this re­gard. The longer the Fed re­mains trapped in this mind­set, the tougher its dilemma be­comes - and the greater the sys­temic risks in fi­nan­cial mar­kets and the as­set­de­pen­dent US econ­omy. It will take a fiercely in­de­pen­dent cen­tral bank to wean the real econ­omy from the mar­kets. A Fed caught up in the political econ­omy of the growth de­bate is in­ca­pable of per­form­ing that func­tion. Only by short­en­ing the nor­mal­iza­tion time­line can the Fed hope to re­duce the build-up of sys­temic risks. The sooner the Fed takes on the mar­kets, the less likely the mar­kets will be to take on the econ­omy. Yes, a steeper nor­mal­iza­tion path would pro­duce an out­cry. But that would be far prefer­able to an­other dev­as­tat­ing cri­sis.

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