After the Fed’s “Twist” Comes the Hard Turn
The U.S. Federal Reserve's "operation twist" – an attempt to flatten the yield curve by buying long-term bonds with proceeds from sales of short-term securities – is supposed to end this month. A much more challenging phase of monetary policy will follow. To support a broadening expansion of aggregate demand, the Fed will have to lead the economy from crisis management to the path of steady and noninflationary growth.
That will be neither simple nor easy.
At $2.6 trillion, the Fed's monetary base (the only monetary aggregate it directly controls because it is the right-hand side of its balance sheet) has more than tripled from its pre-crisis levels. That will have to be brought down while keeping the economy up and growing.
At the same time, there will have to be a major correction of the current interest rate structure. That, too, will require a large adjustment: assuming (implausibly) that the current inflation rate of 2.2 percent stays constant, the federal funds rate (the only interest rate the Fed directly controls) would have to be raised from zero to more than 4 percent just to reach a neutral policy stance.
As things now stand, the Fed seems in no hurry to do any of that.
The monetary base continues to grow. Last month, it rose 1 percent from October and nearly 2 percent from the year earlier. That is reflected in the Fed's money market operations, where there are no signs of any policy change. Not even a switch from the automatic pilot of the 0.25 percent federal funds rate to the "manual control" of a data-driven monetary policy advocated by some Federal Open Market Committee (FOMC) members.
Quiescent inflationary expectations, an unemployment rate of 7.9 percent and fears of a sudden, and large, fiscal tightening (the "fiscal cliff") appear to be the key factors behind the Fed's determination to keep its present policy settings unchanged.
Missing the Turning Points
In spite of that, I do believe that the Fed's pledge to keep zero interest rates until 2015 is far-fetched. I am, therefore, a bit more optimistic than some famous investors, recently turned gold bugs, who are reaching for the bullion because they fear that the Fed is brewing an inflationary flare-up.
(Read More: Fiscal Cliff: Complete Coverage)
But these newly minted gold aficionados have a point. Managing a transition from a crisis-ridden economic recovery to a stable and sustainable growth path is an extremely challenging task. The difficulty there is well-known: monetary policy seldom, if ever, adjusts correctly to turning points in the business cycle – the position where the U.S. economy appears to be at the moment.
These errors stem from the fact that the Fed does not have a perfect foresight; it just has to keep guessing as to where these turning points might be in order to calibrate the policy.
Here is an example of how difficult these things are.
Monetary policy is a broad and powerful instrument operating with long and variable lags. And here is the problem: there are no precise measurements of the length and variability of lags in the impact of monetary policy; it is all a matter of estimates -- not much better than pure guesswork.
To make things even more difficult, whenever the Fed contemplates a policy change it would have to know, with a high degree of precision, where in the business cycle the economy is. And the Fed would also have to know where the economy will be at the time its policy change (a rate hike or a rate cut) will begin to move interest-sensitive components of aggregate demand (household consumption, residential and business investments – about 82 percent of the U.S. economy).
Booms and Busts Are Errors of Monetary Policy
The Fed can only take a guess at all that. That is why the Fed's pledge of zero interest rates until 2015 rings hollow. Equally questionable is the Fed Chairman Ben Bernanke's statement that the huge excess liquidity in the U.S. financial markets can be withdrawn before it becomes a threat to price stability.
Most charitably, this statement could perhaps be taken as Mr. Bernanke's promise to do a much better job than the last time, when his failure to catch a rather glaring turning point pushed the U.S. economy into a Great Recession. Indeed, while the economy was growing well below its potential growth rate of 3-3.5 percent in 2007, the Fed was maintaining an effective federal funds rate of about 4.5 percent. And when the Fed finally began to ease in earnest in late 2007 and early 2008, the economy was already in an irretrievable downturn.
Equally unforgivable is the fact that the Fed failed to see an even more dangerous "turning point": America's entire financial system was going bankrupt. By the time the Fed's rescue operations were peaking out in November 2008, the U.S. economy was sinking at an annual rate of 5-6 percent.
The Fed has a tough and humbling job, for all the reasons explained earlier. This is by no means a yet another go at a gratuitous criticism of its track record. It is just a simple reminder of an old and well-established empirical finding: booms and busts are always created by errors of monetary policy because the stimulus (or credit tightening) is maintained well past the point where it is needed.
What Should Investors Make of All This?
Sell bonds. Buy equities and commodities. Go easy on gold.
Profits of American companies will strengthen. Most of the labor costs (hourly compensations) in the first three quarters of this year ( 1.9 percent) were offset by rising productivity ( 1.1 percent) in the non-farm business sector. As the economy continues to accelerate, the ensuing labor efficiency gains will boost profits until tighter labor markets begin to push wage claims up. But given a high unemployment rate, rising wages are far from being an imminent threat.
Investors, as opposed to traders, should not be too concerned about the "fiscal cliff" drama, although this one looks like a real milestone in the long history of Washington gridlocks. Difficult political negotiations are rarely, if ever, completed before the deadline (in this case the end of December). But an agreement is quite likely because both sides, especially the Republicans (the president just got reelected and does not have to worry about the polls), know that pushing the economy over the cliff - an unconscionable waste of American jobs and incomes - carries a heavy political cost.
With subdued inflation expectations, the gold price is driven by geopolitical crises and portfolio diversifications of some official reserve holders. Barring major social unrests and broader military confrontations – Iran, Syria and the rest of the Middle East, East China Sea and the Korean Peninsula – gold should not be overplayed.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.