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The Fed is 'tapering,' but that’s the easy part

Dollar bills are seen attached to a computer on the floor of the New York Stock Exchange.
Getty Images
Dollar bills are seen attached to a computer on the floor of the New York Stock Exchange.

The U.S. Federal Reserve (Fed) has started to wind down its monthly asset purchases.

This has been a widely signaled action. The fact that "tapering" is now being implemented suggests that the majority on the Fed's interest-rate-setting committee (the Federal Open Market Committee – FOMC) supports a gradual withdrawal of an extraordinary monetary stimulus.

So, here it is: According to the Fed report published on September 12, 2013, the growth rate of its balance sheet slowed down during five reserve reporting intervals between early July and early September to an average of 1.5 percent. That is a substantial deceleration from an average monthly growth rate of 3 percent in the first half of this year.

(Read more: Here it comes: Are you ready for the Fed to taper?)

Bond markets seem to have taken no particular notice of this event since the numbers were published last Thursday.

The Fed must be pleased by that. And the Fed would be right to think that its repeated hints since last spring about terminating its program of $85 billion in monthly purchases of U.S. Treasuries and mortgage-backed securities – code-named "tapering" – largely disarmed bond market vigilantes who use asset pricing under conditions of uncertain policy intent like a lethal weapon.

By doing that, the Fed shifted the guessing game to event timing, with relatively minor market disruptions, as asset valuations were brought more in line with economic fundamentals.

As of last Friday, for example, the yield on the ten-year Treasury note (2.89 percent) was less than 60 basis points above its mid-June level, and vigilantes' assaults on the 3 percent yield were repeatedly thwarted by data on the U.S. economy. That was clearly the case as markets fretted about lackluster retail sales, rising business inventories, declining consumer sentiment and Washington's ongoing fiscal disputes.

Residential mortgage markets tell a similar story. As the cost of long-term credit remained relatively contained, the 30-year mortgage rate (4.84 percent last Friday) increased less than 80 basis points since last June, despite steadily rising property prices being driven by a robust housing demand.

(Read more: Three reasons not to fear the taper)

Fed's policy remains hugely expansionary

Markets now have to get over another allegedly "confusing" event. They expect that the FOMC will downgrade its growth forecasts at this week's meeting, while maintaining its intention to discontinue, or substantially reduce, monthly asset purchases. Most media reports take that as proof of a "confusing and inconsistent monetary policy."

The Fed probably thinks otherwise, as there is nothing inconsistent here once you get past the usual (inflation-recession) binary reasoning.

The first thing to note is that the Fed is just another short-term forecaster, changing its mind as data change. Apart from that, cutting down last September's 2.9 percent estimate for this year's economic growth to less than 2.3 percent (last June's forecast) would just bring the Fed's analysis closer to the mainstream ("consensus") views of the current U.S. growth dynamics.

It would be an overdue adjustment because the Fed's existing forecasts imply an implausibly fast acceleration from the growth rate of 1.4 percent recorded in the first half of this year.

And there is no inconsistency between the expected revision of Fed's growth estimates and the removal of asset purchases, which are an unnecessary addition to an already extremely accommodative credit stance. Remember that the Fed's effective federal funds rate of 0.09 percent as of last Friday is less than half the target rate of 0.25 percent. It is therefore perfectly consistent to think – as some Fed governors apparently do – that virtually free funds in interbank markets are more than enough to support the strengthening U.S. economy.

"Tapering" is easy; rate hikes will be more disruptive

There are a number of important messages here.

(Read more: Fed taper impact unclear, volatility certain: StanChart)

First, the Fed's successive downgrades of its own U.S. growth forecasts indicate that they were repeatedly surprised at how ineffective their monetary policy has been in accelerating the economic recovery.

Second, the Fed's asset purchase programs – intended to keep long-term rates down to stimulate interest-sensitive sectors of aggregate demand – betray an understandable concern about the slow-acting stimulus of near-zero federal funds rates since late 2008.

Third, the Fed is acutely aware of growth obstacles posed by huge structural damages caused to the U.S. economy by excesses of inappropriately loose credit conditions and a total failure of financial supervision. The Fed surely knows better than anybody else that the process of post-crisis healing takes a long time.

Fourth, in the financial jargon most of that healing is called deleveraging – a process where economic agents use their resources to pay down excessive debt instead of spending and investing. To get an idea of how serious that problem had become, just think that America's total private and public debt is put at close to 300 percent of gross domestic product (GDP), with household liabilities estimated at 117 percent of GDP.

Fifth, the deleveraging process is made longer and more painful by high unemployment, stagnant personal disposable incomes (0.5 percent annual growth in the first half of this year) and banks' reluctance to lend to consumers and accumulate risky assets on their recovering balance sheets. Bank lending to households (43 percent of all consumer loans) rose only 3.4 percent in the year to July, despite a record $2.2 trillion of excess reserves banks can lend.

(Read more: Worst case for Fed taper: mere market 'indigestion'?)

This shows that the Fed's arduous task of seeking a short-cut to faster economic growth with asset purchases has been taking place in a maelstrom of deleveraging and gun-shy financial intermediaries. The Fed is also struggling against the headwinds of a restrictive fiscal policy caused by Washington's political gridlocks.

The toughest part lies ahead, though. Indeed, the next stage of policy adjustment will be much more difficult and unsettling, because raising the federal funds rate from 0.09 percent to the policy-neutral position of 4 percent will make "tapering" look like a walk in the park.

Follow the author on Twitter @msiglobal9

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.