Mohamed El-Erian: Fed keeps messing with markets


In another few years even gold may get mentioned in respectable commentaries like this.

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The Fed's Second-Best Solution

Mohamed El-Erian
Financial Times, London
Wednesday, June 20, 2012

Pity Ben Bernanke and his colleagues on the Federal Reserve's main policymaking committee. Once again they felt compelled to do something to be seen as countering a renewed slowing of the domestic economy that is compounded by a deepening European crisis and less buoyant emerging economies. But in continuing to act on its own, all the Fed will do is buy some time that will again be wasted by the country's politicians. Meanwhile, collateral damage will mount, making the next policy steps even more excruciating.

It is not so long that the Fed was discussing how to exit the unconventional policy phase initiated in the midst of the 2008 global financial crisis. Instead, and having already ballooned the balance sheet to 20 per cent of US gross domestic product, it will now exchange even more of its short-term Treasury holdings (up to 3-year maturities) for longer-dated (6-30 year) bonds. This extension of "Operation Twist" has, as an intermediate objective, repressing market interest rates to push investors to assume more risk, trigger the wealth effect, and reignite animal spirits. The ultimate objective is, of course, to promote non-inflationary growth.

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While the Fed has been able to normalise market functioning and boost valuations, it has repeatedly failed to deliver on its desired economic outcomes. Unfortunately, there is little to suggest that things will be any different this time around.

Whether you are worried about insufficient demand or the economy's sluggish supply response, it is hard to argue that what ails the US is in the domain of Fed tools. The most it can do is buy time while trying to inform and -- at the margin -- influence steps that can only be taken elsewhere.

The Fed can again try to slow the inevitable deleveraging of over-indebted parts of the private sector. But, given the liquidity trap, it won't meaningfully counter lower government spending, consumers' debt overhang, and less dynamic export markets. It cannot get Congress to agree on fiscal reform, nor will it remove the housing inventory, revamp housing finance, boost infrastructure, and enhance labour retraining and retooling.

What this continued Fed activism will do is to continue altering the functioning of markets, contaminate price discovery, and distort capital allocation. Already, the viability of several segments -- from money markets to insurance and from pension provision to suppliers of daily market liquidity, all of whom provide financial services to companies and individuals -- has been undermined. The Fed has also conditioned many market participants to believe in a policy put for both equities and bonds. And other government agencies are relieved to have the policy spotlight remain away from their damaging inactivity.

Yet, judging from Wednesday's decision, the Fed remains undeterred. This is not due to a lack of recognition of the increasingly unattractive balance between what Chairman Bernanke called in August 2010 the "benefits, costs, and risks" of unconventional policies. Instead, I suspect that Fed officials feel a moral obligation to act when others won't; they worry that their flexibility will erode as they get closer to the November elections; and the last thing they want is to inadvertently contribute to a sluggish US economy that would accentuate the synchronized slowing now taking holding of the global economy.

The Fed also remembers last summer when political brinkmanship over the debt ceiling took the country to the edge of a technical default and contributed to the loss of a triple-A sovereign rating. Now, due to the serial postponement of key congressional decisions, the US faces the menace of an end-year fiscal cliff -- a disorderly contraction of some 4 per cent of GDP through arbitrary spending cuts and across-the-board tax increases -- at a time when the economy as a whole is on course to deliver at best just 2 per cent in annual growth.

Wednesday's decision signals that America is falling further behind its first best policy responses. And while the Fed should be commended for trying to deliver a second-best, net benefits will prove even more difficult to secure. In the process, look for greater distortions that will take years to resolve.


Mohamed El-Erian is the chief executive and co-chief investment officer of Pimco.

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