Why Bernanke and the Fed made the right decision

THE US Federal reserve has been roundly criticised for its decision not to start tapering, as was expected, at its FOMC meeting last week. But how fair is the criticism? It should be remembered that chairman Ben Bernanke has a very difficult task on hand. There are no easy solutions as the market seemingly believes.

Against this background it seems that the Fed took the prudent decision, despite the obvious reality that forward guidance is not working as well as it should.

Forward guidance is based on the premise that central banks will keep rates low, based on economic indicators, of which an improvement in unemployment is the most important.

Bernanke’s dilemma is that if he reduces quantitative easing (QE) through tapering too quickly, it could damage the US and global economies to such an extent that a depression could become the reality. But if he waits to long, further asset bubbles could be building up in markets, thereby also threatening the fragile recovery now evident.

What has happened over the past five years is not exactly what QE intended.

The whole idea was to increase liquidity in the economy, and thereby boost growth and job creation.

But unemployment in the US and UK is still above 7% and growth remains tepid.

Investors and consumers have been far too busy with repaying debt and investing in stock markets, which have recorded one high after another.

This has dangerously increased inequalities in society, threatening a very repeat of the 1933 depression which Bernanke wishes to avoid. Lower and middle-income groups are under pressure in many countries, despite QE, due to rising debt and job losses.

But the rich are just getting richer and richer.

Bernanke’s obvious aim is to normalise the economy again by doing away with QE. But clearly he is unsure about the strength of the US economy, hence the extension of the tapering decision.

It is now becoming more unlikely the US economy will strengthen to such an extent that starting tapering will be the obvious choice at the next FOMC meeting in October.

And then there is only one meeting left in December before Bernanke is replaced, leaving little room for starting tapering in any meaningful way.

That leaves many more months of uncertainty as well as expected further asset growth in equity markets, thereby perpetuating a possible bubble.

Bernanke and the Fed could rightly feel aggrieved they are blamed for the mess.

Right from the start in May he emphasised that tapering is depen- dent on economic conditions improving. For it to happen, unemployment must fall to 6.5% from the present 7.3%, or 7.6% then. This was done because the Fed wanted to see an improvement in the broader economy, and not only higher stock markets.

With unemployment still above 7%, there was no reason to start with tapering last week.

Instead the herd mentality among markets and investors prevailed. The consensus, as was stated by analysts and economists, was that tapering would start on a small scale with cutbacks amounting to only $5-10bn of the present $85bn monthly asset-buying programme.

This view was based on divergent and less important economic data and not on unemployment.

In this process spurious comments from the Fed did not help, as it did not dispel the consensus view. If it did that, it would have moved much to close to the market view, thereby losing its independent, decision-making stance.

For the Fed it has become uncomfortably evident that the causes of a depression do not dissipate thanks to QE. Even if liquidity is pumped up, something which did not happen in 1933, there is still no guarantee that the economy will recover and that money will be spent productively for the betterment of all.

The reason is that for free economies to grow, faith and confidence in the macroeconomic system has to be restored by reducing unemployment.

If that does not happen, uncertainty and a hoarding of assets will remain the norm, just as with the Great Depression of 1933.

That is why Bernanke and the Fed made the right decision at the end of the day for now. But the road ahead still appears perilous.