El-Erian: Unprecedented Fed to the Rescue
After Monday’s gut wrenching 635 point fall, the Dow Jones index surged an impressive 430 points on Tuesday. In the process, investors experienced a wild 640 point intra-day roller coaster! Gold prices set another record while Treasury yields fell sharply, with the 2-year closing at an eye popping 0.2% and the 5-year at an equally stunning 1.0 percent.
Tuesday’s combination of unusual, if not unprecedented, market moves had a lot to do with the Fed. Once again, the institution came to the rescue of an equity market under severe pressure, and did so in a bold manner.
For the first time in history, The Fed announced that it anticipates “exceptionally low levels” for its policy rate — basically 0 percent — will be warranted at least through June 2013. It also reminded investors that it stands ready to use a range of other policy tools.
Judging from the three committee members that voted against it, Tuesday’s Fed decision was a difficult and controversial one. Indeed, this degree of public dissention, something that has not happened since 1992, is uncomfortable for an entity that prefers consensus and collegiality.
So, why all this?
The usually upbeat Fed significantly revised down its outlook for the economy and communicated using uncommonly strong words for a public sector entity. In also pointing to higher “downside risks,” it acknowledged that transitory (that is to say, temporary and reversible) drivers explain “only some” of the considerable headwinds to growth and jobs.
There are three important bits of good news for markets in what the Fed did on Tuesday: First, it recognized what most Americans already know — the US economy is in bad shape and could well get worse; second, it grudgingly admitted that the reasons are partly structural in nature; and third, it announced a previously-unthinkable policy response.
No wonder markets reacted in the way that they did — enthusiastically welcoming both the more realistic assessment from policymakers and their willingness to think out of the box.
For this to be sustained, I suspect that markets will look for three other things: First, evidence that the Fed is not just willing to take bold action but is also effective in doing so; second, the ability of the Fed to hand off, hopefully sooner rather than later, to government agencies with legal power to remove structural impediments to investment, employment and prosperity; and third, no more drama out of the European debt crisis.
By boldly and controversially stepping up to the plate with an imperfect policy instrument, the Fed is again assuming considerable reputational and institutional risks. In the process, it ends up carrying even more of the policy burden.
Like its counterparty in Europe (the ECB) last Sunday, the Fed’s intention is to provide a bridge for other, glacially-moving economic agencies. Let us hope that these agencies will finally get their act together. Otherwise, the Fed will simply be providing an expensive bridge to nowhere.
Mohamed A. El-Erian is CEO and co-CIO of PIMCO, and author of "When Markets Collide".