The Federal Reserve

Clearer, but less cuddly

Ben Bernanke is right to keep on

buying bonds, and to explain when he
might stop
FOR the past six weeks financial markets have been in a tizzy about “tapering”—central-
bank jargon for the process by which the Federal Reserve plans to slow the pace at
which it prints money to buy bonds (“quantitative easing”), from the current clip of $85
billion a month. Since early May fear of the end of ultra-cheap money has driven yields
on ten-year Treasury bonds up by over 40%. Emerging-market currencies and bonds
have wobbled. Some worry about parallels with 1994, when tighter Fed policy caused
global financial turmoil.

The recent jitters show how bumpy the exit from super-loose monetary conditions might
be. But it was also the result of poor communication by America’s central bankers.
Various Fed governors had given speeches suggesting that a slowing of bond purchases
was imminent, but were putting out mixed messages about why, how and when tapering
might start.

The Fed’s meeting on June 18th-19th was never going to end the bumpiness. But it
offered a chance for some much-needed clarity about the central bankers’ plans. And, by
and large, they made the most of it (see article). They sensibly decided that there should
be no immediate slowing of bond purchases, because the risks of scaling down the
scheme still outweigh those of buying more bonds. At the same time the Fed’s chairman,
Ben Bernanke, made clear that if the economy continued to improve as expected, the
pace of bond-buying would slow towards the end of the year. When America’s jobless
rate was down to 7%, which Mr Bernanke expects to be in the middle of 2014, the Fed
planned to stop buying new bonds.

The transparency was admirable, but Mr Bernanke should beware of tapering too soon.
The case for keeping up the pace of bond-buying is strong. Since September 2012,
when the Fed stepped up its bond-buying scheme and promised to keep it in place until
there was a “substantial” improvement in the labour market, the unemployment rate has
fallen from 7.8% to 7.6%, and output has grown at a pace of around 2%. Although these
figures point to a recovery, it hardly looks like a spectacular one. This week the Fed
actually lowered its forecast for growth in 2013 slightly to 2.3-2.6 %. Given that America
is undergoing a budget squeeze worth around 1.75% of GDP, this growth rate is not bad.
But with politicians determined to tighten fiscal policy too fast, the central bankers need
to stay loose for longer.

America’s inflation also argues for erring on the side of looseness. Consumer-price
inflation is unusually low, and falling. The Fed’s preferred measure, the core personal-
consumer-expenditures index, is up by 1.05% year on year, the slowest rise in its 50-
year history. And investors’ expectations for future inflation have slipped sharply in recent
weeks. Not only are consumer prices rising more slowly than the central bank’s target,
but lower expectations for future inflation mean that the real cost of borrowing (nominal
interest rates adjusted for expected inflation) has risen. Though neither trend is sharp
enough to signal deflationary worries, they still argue for exiting slowly, if at all.

The strongest argument in favour of tapering the bond-buying soon is that its economic
benefits are diminishing, and the potential distortions from having the Fed own boatloads
of bonds are rising. That may be true. But even if it were, tapering should be undertaken
cautiously. The pattern of the past few years has been for the Fed to scale back its bond-
buying only to restart it again as the recovery disappointed. The best way to avoid such
a relapse, and the distortions of prolonged bond-buying, is to stay looser for longer,
ensuring that economies reach “escape velocity”, as Mr Bernanke puts it.

It’s not what you do, but the way that you say it

The other way to minimise the risks of prolonged bond-buying is to be as clear as

possible about the circumstances in which it will end. Vague references to a “substantial”
improvement in the job market were not enough. That is why Mr Bernanke’s specificity
this week was so important. In a zero-interest-rate environment the central bank can
influence monetary conditions more through words than through actions. Its most
powerful tool is its ability to influence investors’ expectations of future inflation.

But therein lies the rub. Ten-year bond yields rose sharply after the Fed meeting, as
investors interpreted the clarity to mean greater hawkishness. They may well be wrong.
Mr Bernanke took pains to point out the path to tapering was “data-dependent”. If
inflation remains uncomfortably low or growth proves weak, the central bank could
continue to buy bonds. But it is also possible that in their desire to get out of the
business of bond-buying, America’s central bankers are engaged in some wishful
thinking about the future path of the economy. And that could lead to more bumpiness
ahead.