Opinion

James Saft

Meet the new Fed, same as the old Fed

October 9, 2013

Oct 9 (Reuters) – The Yellen era will feature more of the
same: the same monetary policy and the same unanswered
questions.

Appointed today as Ben Bernanke’s successor as Fed chief,
Janet Yellen is likely to pursue a similar approach to monetary
policy. That makes any taper in bond buying likely to be later
and gentler, a factor which will support, all things being
equal, riskier assets.

Less clear, and also unchanged, is how she and her highly
divided colleagues at the Fed will react as yet another year of
unsatisfactory growth and low inflation call into question the
wisdom of the whole approach.

What this means is that riskier assets like equities will
probably do better in the short term under Yellen than under the
alternative choices, notably Larry Summers, who withdrew from
consideration last month. That ‘better’ performance, however,
comes at the price of some serious embedded risks.

First, let’s look at the just-released Fed minutes from the
September meeting, at which they took the decision to delay the
taper amid what looks from the outside like much disagreement
and unease.

Fed officials in favor of holding off on tapering feared how
well the economy could withstand less bond buying, and the
tighter conditions tapering implies.

“The announcement of a reduction in asset purchases at this
meeting might trigger an additional, unwarranted tightening of
financial conditions, perhaps because markets would read such an
announcement as signaling the Committee’s willingness,
notwithstanding mixed recent data, to take an initial step
toward exit from its highly accommodative policy,” the minutes
said.

The opposing view: that delaying would undermine the central
bank’s credibility and make it only more difficult to climb down
from the position later.

Sadly, both arguments are, if anything, now more true than
in September.

The budget impasse, especially the possibility that the U.S.
may shortly default on its debt, leaves the doves with more
reason to believe that higher interest rates – which is what
tapering means for us in the real world – don’t make sense.

And Yellen will, as the hawks clearly fear, be in a position
where she must guide a market with less faith in her
institution’s transparency and in its commitment to so-called
forward guidance, a fancy monetary policy term for convincing
people that you will or won’t do something far in the future.

DIVISIONS MULTIPLY

Remember too that when we say Yellen embodies continuity,
what we really mean is that unlike Summers she hasn’t got a
track record of over-confidence breeding major errors. She is
human, however, and though superbly qualified, may well diverge
in time from Bernanke’s policy path.

Indeed that Bernanke himself was close to leading the
consensus of the FOMC to tapering is evidence that he may well
have become more hawkish and less asset-inflation-friendly had
he taken a third term.

The Fed is highly divided, and with good reason.

Those arguing against tapering see, rightly, an economy with
low participation in the workforce, poor job creation and
below-target inflation.

Those arguing for the taper see, rightly, the risk of
bubbles and the mounting problem of how to get out.

But as QE ages, and as we continue to see little evidence
that it does much beyond encouraging asset price inflation,
capital misallocation and increasing economic inequality, expect
more pressure and more divisions.

To be sure, the current morass in Washington may,
ironically, cause the Fed to close ranks behind continued QE. I
have little doubt the Fed will respond forcefully to a default
and to the financial market dislocation that would ensue.

Should a default happen, not only won’t tapering happen, but
the Fed will do its best to provide additional stimulus.

That’s both right and proper and a real shame. Right and
proper because a default would deal a real blow to the economy
and would dislocate markets in a way which only a central bank
can handle. A shame because it would extend what is looking like
a failed experiment in monetary policy, and because it would
reinforce the Fed’s role as provider of insurance against dumb
behavior.

For investors, the advent of the Yellen Fed highlights two
conflicting truths.

First, investors ought probably to take on more risk, or
rather keep their portfolios relatively aggressive. The Fed is
paying you to take risk, and so long as the debt debacle doesn’t
lead to fundamental doubts about U.S. creditworthiness, these
are payments it is good for.

Second, investors probably ought to be less optimistic about
long-term returns. All of this misallocation of capital is not
cheap, and we will all pay in the end through lower growth, more
volatility and lower returns.

Sounds a bit like the last 15 years, doesn’t it?
(At the time of publication, Reuters columnist James Saft did
not own any direct investments in securities mentioned in this
article. He may be an owner indirectly as an investor in a fund.
For previous columns by James Saft, click on )

(Editing by James Dalgleish)

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