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Ben Bernanke’s inaugural gift to Janet Yellen

Guest Contributor | |
Monday, 6 Jan 2014 | 7:00 AM ET
Fed out of QE by year's end but low rates linger: El-Erian
Monday, 6 Jan 2014 | 8:40 AM ET
Mohamed El-Erian, CEO and co-CIO of Pimco, provides his outlook on Fed policy, markets and the U.S. economy. Rates will stay lower than markets anticipate right now, says El-Erian. It is unlikely we will end up with high single-digit growth this year.

It wasn't easy for Federal Reserve Chairman Ben Bernanke. It took him and his Fed colleagues several tries. Yet, as he comes to the end of his impressive tenure as Fed chair, he has succeeded in establishing something of immediate value for Ms. Janet Yellen, his talented successor: A quantitative easing exit policy that has been communicated well externally, that markets seem comfortable with, and that has a chance of playing out as planned.

After an unusual period of protracted reliance on experimental QE programs, the Fed is embarking this month on the first ($10 billion) of several reductions in its monthly purchases of securities. Judging from the press conference that followed its policy meeting in December, if the economy evolves as planned, the Fed will regularly lower the pace of purchases throughout 2014 — so much so that, by the end of the year, it would be out of the QE business.


Ben Bernanke and Janet Yellen
Getty Images
Ben Bernanke and Janet Yellen

This is the third time that the Fed seeks to exit QE formally and fully. It had to abandon the first two attempts. Indeed, rather than exit, the Fed was pulled at that time deeper into unconventional policy.

This time around, it stands a better chance of succeeding, and for two reasons: First, our central bankers are partially offsetting the elimination of QE with other, albeit less potent, measures starting with more aggressive forward policy guidance; and second, the macro-economic (growth and inflation) projections that underpin Fed baseline policy are less unrealistic this time around.

(Read more: Ex-Fed official: 'I'm sorry for QE')

With that, Ms. Yellen inherits on day one a policy framework that offers the possibility of exiting QE3 before its collateral damage and unintended consequences become too severe — and in a manner that markets can price in an orderly fashion.

Under the best of circumstances, and assuming the compensating measures are effective, this would also suggest a market trio that would be quite constructive for employment, the Fed's main policy concern at this stage: muted market volatility, a well behaved front end of the yield curve, and artificially-boosted values for risk assets that can eventually be validated by fundamentals.

(Read more: Headaches may be just starting for Yellen)

While markets have reflected the Fed's QE exit baseline, it appears that they are yet to fully price in the more aggressive forward policy guidance that comes with it. Specifically, market-determined shorter-dated interest rates may currently be anticipating policy rate hikes earlier than what is likely to materialize. As such, the recent unfavorable moves in some components of the economy's financial condition indices may not be as worrisome as some believe.

Yet Chairman Bernanke's inauguration gift to Ms. Yellen, as valuable as it is upfront, doesn't guarantee automatic and predictable tranquility for her. There are still quite a few things, internal and external, that could hinder this — a reflection of the complex medium-term policy issues that she inherits.

Business investment has been held back by headwinds that are yet to be addressed fully. Certain persistent aspects of the country's unemployment challenges, including long-term and youth joblessness, has been getting more firmly embedded in the structure of the economy. Residual debt overhangs frustrate timely market clearing. Politics is hindering rather than facilitating the economic recovery.

Meanwhile, no one is quite sure about the lasting damage that QE may have already made to the functioning of markets, asset allocations and related asset prices. Prolonged Fed reliance on the "asset channel" has also accentuated concerns about income and wealth inequalities. And several emerging countries are yet to regain full policy control of economies that have been buffeted by the side effects of QE.

(Read more: How to prepare for the first huge number of 2014)

Individually — and certainly together — these factors suggest that the "goldilocks" macro-economic scenario underpinning the Fed's QE baseline may be subject to greater uncertainty than is currently anticipated by markets. They also point to the best gift that a Yellen Fed could provide to the country, and which some risk markets are now expecting: completing the complex and tricky handoff from policy-induced growth to genuine and durable private sector-led growth.

Unfortunately, this more holistic handoff hasn't been completed this gift-giving season. Indeed, it will take time and it faces quite a few challenges. Hopefully, it won't be too many holiday seasons.

— By Mohamed El-Erian

Mohamed El-Erian is the CEO & co-CIO of Pimco. Follow him on Twitter @pimco.

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